“…now, thanks to technology, we have a whole new paradigm.  No, a richer paradigm…My point is understanding institutions and how they make implementation of these ideas possible.”

(Nobel Laureate Robert Merton, quoted by Peter Bernstein) 

In our final posting on Peter Bernstein’s new book Capital Markets Evolving, we thought we would pass along some of the pearls of portable alpha wisdom in it.  While the book covers several topics of interest to readers of this blog (efficient markets, validity of the CAPM, 1X0/X0 etc.), we will focus our attention on the core themes of portable alpha and its enablers. 

Bernstein addresses these themes early in the preface to the book, setting the following context:

Alpha and beta – once upon the time the unpalatable language of the Capital Asset Pricing Model – have become critical ingredients in the most sophisticated forms of portfolio management and investment performance measurement. (page xvii)

While Capital Ideas focused on beta – the behavior of markets and how to price portfolios in light of that behavior – Capital Ideas Evolving focuses on alpha – or the achievement of returns in excess of some benchmark. (page xxii)

Then after covering several of the other issues in the first half of the book, he turns his attention to the beautiful variable:

…Alpha is the focus of attention in most of what follows in this book  As we shall see, the widespread struggle to earn a return above what the market earns, after adjustment for risk, has become increasingly sophisticated and elaborate. (page 169)

The Widespread Struggle

Like every worthy struggle, this one has its own grand prize.  Reflecting the mystery of alpha, Bernstein resorts to religious imagry to describe its wonders.

alpha has become the holy grail of investment management (page 93)

Alpha is the nirvana all active managers claim they can consistently produce for their clients (page 169)

But he acknowledges that what appears to be alpha might actually be a simple mirage – potentially turning this religious quest into Monty Python’s Search for the Holy Grail of Investment Management. 

positive alpha is still difficult to identify beyond doubt.  Benchmarks are mushy, risk measurements are arbitrary, and what we want to classify as alpha, or beating the benchmark, is often just the return to systematic risk, or beta. (page 38)

(Benchmarks: the real Killer Rabbit of Caerbannog) 

Porting Alpha “The Rage”

Portable alpha is now the rage. (page 176)

Bernstein dedicates several chapters to portable alpha and alpha/beta separation.  As a money manager himself, he is acutely aware of investors’ growing interest in hiring separate managers for the alpha and beta portions of their portfolios.

investors are now asking why they should retain the same managers to produce both beta returns and the hoped-for alpha return…why pay full fees for receiving the return on the market, when today passively managed index funds make the market return available at fees of ten basis points or lessnow investors are asking ‘Why not separate the management of beta returns and alpha returns instead of leaving them conjoined as they have always been?’  This step would not just reduce the costs of portfolio management; it would focus attention where attention should be focused: on returns in excess of market returns, after adjustment for risk exposures. (page 174)

…but physical separation not required

The book contains a chapter about Marvin Damsma, the CIO of BP’s pension plan.  While Bernstein describes Damsma as a pioneer in portable alpha, he points out that the physical separation of alpha and beta is not actually a prerequisite to alpha-centric investing.

Damsma’s fund can more effectively tailor the incentive structure to align the interests of managers with the fund.  The system is, in fact, similar to the types of performance fee models used in the hedge fund worldIt does not create alpha.  It merely separates the search for alpha from the search for basic asset class returns. (page 187)

(Marvin) Damsma (CIO, BP Pension Plan) is convinced that performance and efficiency can be significantly improved when the two forms of risk – beta and alpha – are viewed under two separate lenses.  (footnote: That does not mean the two have to be under two separate managers, but they usually are these days.) (page 183)

We were pleased to see this case study included.  Not only is alpha-centric investing all about portable alpha per se, but it also describes a paradigm that is broader than physical alpha/beta separation.  Alpha-centric investing is also a way of analyzing, measuring and charging for long-only portfolios.   Bernstein’s footnote on page 183 makes this point.  (Too bad it’s only a footnote).  

Enabling “Technologies”

This website contains a couple of postings describing derivatives as a new technology that – like any new technology – has the potential to disrupt current value propositions and enact fundamental restructuring of industries.  In short, alpha-centric investing is a product of very recent innovations, not (just) a marketing flavour of the month.

Bernstein makes a similar observation about the recent interest in alpha-centric investing:

Today, in response to the rapid pace of financial innovation – often called financial engineering – the process of separating beta management and alpha management is commonplace. (page 176)

 Portable alpha is more than just a major development in the uses and understanding of the Capital Asset Pricing Model.  Its relevance to Capital Ideas goes further than that.  Without the use of a variety of forms of options, and the Black-Scholes-Merton option pricing model to price them, the whole process might have languished on the pages of learned treatise like Joanne Hill’s, as a brilliant idea without a means of implementation.  In many ways, the active and incessantly creative markets for derivatives make the whole process possible. (page 195)

This is a important point since there are those who believe alpha-centric investing is a fad (cyclical by definition).  We might be more sympathetic to this concern if alpha-centric investing had come on the scene artibrarily – accompanying no other fundamental changes in the financial services industry.

But the coincident emergence of a myriad of new financial technologies suggests alpha-centric investing may in fact be a secular response to these shifts, not just a cyclical trend.  Arguing otherwise would be similar to saying spreadsheets were just a trend that was purely coincidental with the emergence of the personal computer.

Implications for the Asset Management Industry

Finally, Bernstein makes a prophetic statement about the future of the asset management industry.  Like us, he says the bifurcation of portfolios will eventually lead to a bifurcation of the industry itself along alpha and beta lines:

the traditional stock-picking manager with a no-short constraint is gradually becoming obsolete, to be replaced by low-risk enhanced equity products or by high-risk long/short hedge funds. (page 232)

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