By: Bob Litterman, Goldman Sachs
Published: 2005

Excerpt:

“Alpha is hard to come by. Every day, investors scour the markets searching for the road less traveled, hoping to capitalize on inefficiencies before other market participants can do the same. But, what if you could generate alpha from more sources than conventionally thought? In fact, returns exist along a continuum – from beta, to exotic beta and ultimately, to alpha. By optimizing this spectrum of return sources, investors can achieve a more efficient portfolio.

“Market convention, however, is to call the exposure to any asset class or risk factor, not just the market portfolio, a beta.  In deference to this convention, we will follow a growing trend to refer to an exposure to a risk factor that is both uncorrelated with global markets and has a positive expected return – such as commodities – as exotic beta.  The adjective exotic distinguishes it from market beta, the only beta which deserves to get paid a risk premium. The excess return from an exotic beta is alpha, and therefore, exotic betas should be included as a source of alpha in a portfolio.

“If exotic beta is alpha, why bother to distinguish between them? The main reason is that exotic beta has more attractive characteristics – its lower turnover allows for higher capacity, longer sustainability and lower management fees.”

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