Manufacturing Alpha from Beta
Dec 19th, 2006 | Filed under: CAPM / Alpha TheoryBy: 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.
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