Alpha? ...Or polished beta?

“Core-satellite” investing is often regarded as a precursor to portable alpha and various other modern portfolio construction techniques.  However, the popular definition of the term usually refers to a passive “core” and an active “satellite”.  And as we have argued extensively on these pages, active management too often contains a large amount of embedded beta.  Ideally, in our view, core-satellite would involve a beta core and a (pure-) alpha satellite.

This is essentially the same argument presented in a recent paper by Swiss researchers called “What if alpha is just polished beta?“.  The study was authored by Erik Wallerstein, Nils Tuchschmid & Sassan Zaker – the authors behind a paper we covered last week on the performance of hedge fund replication products.

The trio question whether funds of hedge funds should even be in the high-alpha “satellite” allocation in the first place.  They reason that if funds of funds can be replicated passively, then they should be disqualified from being satellites and should instead be treated as part of the core (beta) portfolio.

They use a simple linear model with 5 factors (the Russell 2000, the MSCI EAFE, the Barclays Agg, the GSCI and the CBOE S&P 500 BuyWrite Index) to replicate the HFRI FoF index.  As you might guess, they find this to be the case.  In fact, check out the tiny tracking error of this simple model (click to enlarge): More…