All Alphas are Not Created Equal (2 of 3)
Jul 4th, 2006 | Filed under: CAPM / Alpha Theory, Portable Alpha & Alpha/Beta SeparationBy: Bob Litterman, Goldman Sachs
Published: 2003
Excerpts:
“Traditionally, active risk has been a by-product of manager selection within specific asset classes. But, in Active Alpha Investing, derivative instruments can be used to separately manage sources of risk. As discussed in our previous article, separating these risks allows plans to size and monitor risks more effectively – facilitating a more efficient allocation of risks. It also allows plans to consciously take and pay only for risks they want to be taking.
“And, because active risk is uncorrelated with market risk, we believe, this approach should allow plans to achieve a significant increase in active risk. This only marginally increases total portfolio volatility, but can have a meaningful impact on total expected returns.
“The Active Alpha Investing prescription is clear: to create more alpha, take more active risk. But the question is: how and where? You can look for alpha in many familiar places as well as some untapped new ones. But remember, alpha sources have different key characteristics – so all alphas are not created equal. The process of identifying the best sources of alpha begins with a clear understanding of active risk and return. Active managers tend to confine themselves to areas of the market, or benchmarks, where they possess differential ability.”
“While we expect managers to outperform their benchmarks, true outperformance comes from uncorrelated return. Permanently holding cash or levering the benchmark does not generate active return, but, rather, deviates from the benchmark and subsequently alters the plan’s market risk. Because benchmark exposure is almost free, in our view, you should pay active managers only for uncorrelated active risk.”
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