Portable alpha
Portable alpha? Why "port" NEW sources of return onto OLD sources of return? In down markets most positive alpha gets swamped by negative beta. It also diverts attention from what investors really need: consistent absolute returns from a blended range of truly UNCONNECTED strategies. Different performance sources stand either as a return enhancer or risk reducer.
The portable alpha fad originates from the high risk 60/40 stock and bond asset allocation mania. Haven't we all evolved beyond that by now towards multi-strategy, multi-asset portfolios? Shouldn't investors move to a 5/5/5/5...5 split among strategy classes? An investor risking 60% in public/private equity and 40% in credit/fixed-income is NOT diversified and has NO chance of being able to meet pension liabilities or retirement spending targets. Passive products and traditional thinking are chronic diseases in too many portfolios.
If an investor owns thousands of stocks and bonds, they might think they have spread their risks sufficiently but they have not. Such a portfolio is concentrated in only two asset classes - equity and fixed-income - and just one strategy class - long only. Such lack of portfolio diversification is just too risky. Equity and credit correlations continue to rise in this current bull market and will get even higher in the coming bear market so historical notions of "diverse" asset allocation are not enough.
The initial efforts at asset class diversification into private equity and real estate did not do much to reduce strategy concentration. Long only equity is still long only equity regardless of whether it is public or private while real estate is dependent on a growing economy and benign credit markets and borrowing rates. Those "alternative" investments weren't really very alternative at all. Both derive from the traditional strategy of purchasing an asset, with no risk management or hedging, but often with leverage. Such assets, with their intermittent valuation and illiquidity disguise significant cointegration and dependence on the health of the public stock and bond markets.
Hedge funds are strategy classes NOT asset classes. For a properly diversified portfolio, investors need numerous sources of INDEPENDENT returns. They require strategy and asset class diversification to complement traditional securities. For example, with commodities and currencies, there is not really an "asset-like" return, therefore trading skills are required rather than established "investment" expertise.
Hedge funds generate returns from widely varied strategies and holding periods including, but not limited to, relative value, short selling, spread trading within and between securities and their derivatives, monetizing second order market phenomena through statistical and volatility arbitrage and new proprietary strategies. Similarly new asset classes, often requiring specialist domain expertise, include energy, distressed assets, CDOs, collateralised high yield loans, weather derivatives, movie financing, reinsurance, carbon emissions, fine art and even footballers and other potential return streams yet to be tradeable or investable. All this strategy and asset innovation REDUCES risks, exposures and portfolio dependence on the usual bets of hoping equity indices go up and hoping bond issuers pay coupons and principal.
The current trendy topic is the separation of alpha and beta. This assumes such a performance attribution split is necessary in evaluating and allocating to strategy classes, also known as hedge funds. Even the most "market neutral" hedge fund is dependent on some underlying, possibly changing, market factors. This hyperbolic focus on "Was it alpha or beta?" misses the point. What actually matters is getting a blended portfolio return of 10% or so at the lowest volatility, under ANY economic scenario EVERY year. It may be counterintuitive to some but the MORE different risks you take, the LESS the overall risk in the entire portfolio, provided the exposures are independent.
So why portable alpha? Investors need to escape the mindset of benchmarking everything to stock and bonds. There is no need for a beta overlay; different return sources justify themselves. Obsession with outperformance of a traditional index, rather than absolute performance per se is what caused problems in the first place. If beta is doing well, who cares about alpha? In contrast, if market or strategy beta fares poorly, "outperformance" is unlikely to save the situation, because negative beta usually swamps any positive alpha. What really matters is having lots of completely different, performance generators with numerous strategies across many asset classes. There is no need to "port" these strategy returns onto traditional assets. Even strategies that haven't done well on a stand alone basis, like short biased hedge funds, can add value by smoothing volatility, lessening risk and factor dependencies.
Owning stocks and bonds might be necessary but is NEVER sufficient. And portable alpha isn't the answer, it is having sources of independent returns from as many DIFFERENT strategy and asset classes as possible. The safest option is to have many fund managers doing different things, in different ways, in different assets with holding periods ranging from seconds to decades. That is TRUE diversification.
The portable alpha fad originates from the high risk 60/40 stock and bond asset allocation mania. Haven't we all evolved beyond that by now towards multi-strategy, multi-asset portfolios? Shouldn't investors move to a 5/5/5/5...5 split among strategy classes? An investor risking 60% in public/private equity and 40% in credit/fixed-income is NOT diversified and has NO chance of being able to meet pension liabilities or retirement spending targets. Passive products and traditional thinking are chronic diseases in too many portfolios.
If an investor owns thousands of stocks and bonds, they might think they have spread their risks sufficiently but they have not. Such a portfolio is concentrated in only two asset classes - equity and fixed-income - and just one strategy class - long only. Such lack of portfolio diversification is just too risky. Equity and credit correlations continue to rise in this current bull market and will get even higher in the coming bear market so historical notions of "diverse" asset allocation are not enough.
The initial efforts at asset class diversification into private equity and real estate did not do much to reduce strategy concentration. Long only equity is still long only equity regardless of whether it is public or private while real estate is dependent on a growing economy and benign credit markets and borrowing rates. Those "alternative" investments weren't really very alternative at all. Both derive from the traditional strategy of purchasing an asset, with no risk management or hedging, but often with leverage. Such assets, with their intermittent valuation and illiquidity disguise significant cointegration and dependence on the health of the public stock and bond markets.
Hedge funds are strategy classes NOT asset classes. For a properly diversified portfolio, investors need numerous sources of INDEPENDENT returns. They require strategy and asset class diversification to complement traditional securities. For example, with commodities and currencies, there is not really an "asset-like" return, therefore trading skills are required rather than established "investment" expertise.
Hedge funds generate returns from widely varied strategies and holding periods including, but not limited to, relative value, short selling, spread trading within and between securities and their derivatives, monetizing second order market phenomena through statistical and volatility arbitrage and new proprietary strategies. Similarly new asset classes, often requiring specialist domain expertise, include energy, distressed assets, CDOs, collateralised high yield loans, weather derivatives, movie financing, reinsurance, carbon emissions, fine art and even footballers and other potential return streams yet to be tradeable or investable. All this strategy and asset innovation REDUCES risks, exposures and portfolio dependence on the usual bets of hoping equity indices go up and hoping bond issuers pay coupons and principal.
The current trendy topic is the separation of alpha and beta. This assumes such a performance attribution split is necessary in evaluating and allocating to strategy classes, also known as hedge funds. Even the most "market neutral" hedge fund is dependent on some underlying, possibly changing, market factors. This hyperbolic focus on "Was it alpha or beta?" misses the point. What actually matters is getting a blended portfolio return of 10% or so at the lowest volatility, under ANY economic scenario EVERY year. It may be counterintuitive to some but the MORE different risks you take, the LESS the overall risk in the entire portfolio, provided the exposures are independent.
So why portable alpha? Investors need to escape the mindset of benchmarking everything to stock and bonds. There is no need for a beta overlay; different return sources justify themselves. Obsession with outperformance of a traditional index, rather than absolute performance per se is what caused problems in the first place. If beta is doing well, who cares about alpha? In contrast, if market or strategy beta fares poorly, "outperformance" is unlikely to save the situation, because negative beta usually swamps any positive alpha. What really matters is having lots of completely different, performance generators with numerous strategies across many asset classes. There is no need to "port" these strategy returns onto traditional assets. Even strategies that haven't done well on a stand alone basis, like short biased hedge funds, can add value by smoothing volatility, lessening risk and factor dependencies.
Owning stocks and bonds might be necessary but is NEVER sufficient. And portable alpha isn't the answer, it is having sources of independent returns from as many DIFFERENT strategy and asset classes as possible. The safest option is to have many fund managers doing different things, in different ways, in different assets with holding periods ranging from seconds to decades. That is TRUE diversification.
© posted by Hedge Fund on 3:30 AM
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