Manufacturing Alpha from Beta
Feb 16th, 2008 | Filed under: CAPM / Alpha Theory, Sponsored ContentBy Tristram Lett, INTEGRA CAPITAL -
The title of this article suggests that alpha can be derived from market timing. In the strict statistical sense, it is not considered a source of alpha, but any investment practitioner knows that, relative to a buy and hold position, being in and out of a particular market in a nimble fashion can add value. Of course, being clumsy can subtract value, so this is a practice that does not come without risk. Market timing has a bad reputation, and justifiably so. Historical data lends support to this negative view and, frankly, so does theory.
Market timing is simply difficult to practise. But the rewards are juicy indeed. Do a simple experiment—starting at the beginning of each month, with perfect hindsight, invest all your assets in the better performing of an equity index and cash. There is a substantial over-performance awaiting the prescient investor who can do this in real-time, compared to simply staying perpetually invested in cash or equities. Naturally, such over-performance must be accompanied by significant risk and it is easy to see what it is. Do the same experiment but always invest incorrectly. Substantial underperformance is the result.
How do long-only investment practitioners deal with this? Generally they do it from one or two points of view. Some do nothing and just hold the buy and hold portfolio, frequently rebalancing it to the original asset weights. Others diversify the number of markets they wish to time and limit the amount of timing exposure that will take. The former is a passive strategy and the latter is active. The passive strategy is likely to be the winner over the longer term because its bet requires no information and the portfolio will benefit from mean reversion. The latter traditionally requires forecasts of market returns. Forecasting market returns is the bane of the investment industry. Countless studies show how difficult it is to be consistently right.
So how does an investor manufacture alpha from beta? More…
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