Report: “Exposure yardsticks may provide little insight about a fund’s alpha potential”
May 15th, 2008 | Filed under: 130/30, CAPM / Alpha Theory
Whether one is referring to a 1X0/X0 fund or to some other long/short variant like a market neutral fund, there is often an implicit assumption that the “net exposure” provides all the insight required into the return potential of the fund. For example, many commonly assume that 130/30 funds are “beta neutral” and therefore that the “30/30″ portion will generate pure alpha. But what if that short-extension was just offsetting? To use an extreme example, if it was 30% long the S&P and 30% short the S&P, then there would be no alpha.
A research paper by Morgan Stanley (available here at AllAboutAlpha.com with free registration) reminds us that dollar-weighted exposure is not synonymous with beta-weighted net exposure. But the paper, another in a series by Marty Leibowitz and Anthony Bova, also argues that the beta-weighted net exposure doesn’t really tell us a lot about the potential information ratio (alpha/tracking error) of the fund. To gauge the potential IR of a fund, one should instead look at the ratio of “active” long positions to “active” short positions - or what Leibowitz and Bova call the “active ratio”.
The active ratio, they argue, is more descriptive of the risk/return dynamics of a fund than the more recognized dollar-weighted or beta-weighted net exposure. They say the Active Ratio can reveal how long/short funds and 130/30 funds are really just first cousins:
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This strikes right at the heart of the TRUE definitions of Alpha and Beta ~ they are metrics applied to a series of returns versus a relative benchmark, not commodities to be purchased, or exposures to asset classes.
An active strategy for domestic U.S. stocks may be 100% long 100% of the time, and still measure a Beta that is significantly different from that of the U.S. market benchmark it draws potential long candidates from. Therefore a fund committing X% of their capital to such a strategy may get LESS “Beta” than they would if they committed that X% to cheap index tracking.
In the end, it’s not the activity level that dictates performance potential relative to the benchmark; it’s the quality of the STRATEGY that dictates relative performance, regardless of which benchmark-relative performance metric is used (Alpha, Beta, etc.).