By: Ray Dalio, Bridgewater Associates
Published: June 2006 

Excerpt:

“Properly executed, alpha overlay leads to better investment results with no more risk than traditional investment management for the following reasons: 

1. The total return of a portfolio equals the return of the asset classes invested in and the managers’ alpha; this is equally true if the alpha produced is in the same markets as the asset class or in other markets. As a result, a portfolio constructed by independently choosing the asset class (beta) and the alpha is no more risky than one managed by following the traditional approach (ie, with alphas coming from the same markets as the betas);
2. However, choosing alphas from wherever they are best obtained and through creating a much more diversified portfolio of alphas, a properly executed alpha overlay strategy can produce much better risk-adjusted alphas; Alpha overlay managers can attach their overlay portfolio to virtually any asset class. This allows investors to generate attractive alpha in asset classes that are otherwise difficult to generate alpha in;
3. The risk-adjusted alpha can be easily calibrated to coincide with each investor’s specific risk tolerances.
4. So, with the new paradigm, investors specify the betas they want, independently choose their alphas and tell their managers how aggressively to run the alphas.”

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