By: Tristram Lett, Integra Capital
Published: March 2006, Canadian Investment Review

When faced with disappointment, inadequate resources, or a lack of opportunity, my grandmother used to tell me “If life gives you lemons, make lemonade.”

But according to Canadian investment veteran Tris Lett, the same can also be said of investing.  If life gives you beta, make alpha. Lett points out in this article that dynamic hedging of beta exposure is as good a source of alpha as security selection.

“Creating alpha from beta is a simple notion. If the market is going up, it pays to have the exposure; if it is going down, it saves not to have the exposure and it pays to short it. So what the manager wants to do is harness the upside variance of the market.”

But Lett cautions against the use of beta alone to determine the size of a market hedge because expected returns might not be linearly correlated to the market in question.  (Market) beta is essentially the “best guess” of fund returns given the returns of that market.  It assumes that the chances of the fund beating or underperforming this expected value are perfectly equal – that the fund returns are “normally distributed” around this estimate.

This has important implications for portable alpha strategies that aim to short-out beta exposures in order to “transport” alpha to some other beta portfolio.  The proliferation of options and derivatives means that today’s fund returns are apt to display a “non-normal” distribution.  That is to say, they may be skewed to one side or the other.  Beta still captures the average expected fund return given the market, but this simple average might just be the result of combining a small chance of a large loss and a large chance of a small gain.  So beta alone doesn’t really tell you much about how much of the market exposure you would need to short out to isolate a fund’s alpha.

Instead, Lett advocates the “Omega score” which mathematically combines both volatility and the skew of the returns around the expected return (and, as it turns out, the kurtosis or “fat-tailed-ness” of the return distribution).

“Instead of beta hedging a portfolio to attempt to extract alpha from beta, using Omega metrics involves creating a portfolio consisting of the fund and an appropriate hedging instrument and weighting the hedging instrument to maximize the Omega score. This will not necessarily create a minimum variance portfolio that is defined by a beta hedge. Instead it will create one with superior risk/reward characteristics. Low variance, positive skew, fatter right tails and low correlation to other alpha sources define these superior characteristics.”

- Alpha Male

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