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Browse by CategoryHome » Category List » Alpha/Beta Separation
Sweden’s AP7 pension fund reports on progress of alpha/beta retooling30 June 2008
A great example of an organization that realizes the holistic implications of alpha/beta separation is Sweden’s AP7, one of the country’s many so-called “buffer funds” designed to fund the retirements of its citizens. Regular readers may recall AP7 and its forward-thinking CIO Richard Grottheim. As we reported in January, AP7 has recently awarded what it calls “pure alpha briefs” that are essentially notional overlays applied to the fund’s passive portfolio. A few weeks ago, Grottheim and colleagues including one from the Stockholm School of Economics, revealed how AP7 is set up to undertake this kind of innovation in a new white paper. In this paper, Grottheim and friends propose an org. structure that they say shows “not only significant improvement in portfolio performance, but also a more transparent and cost efficient portfolio structure.” While the authors acknowledge that alpha/beta separation has been used for return attribution for several decades, they argue that it “can evolve to a framework for portfolio management“. Beyond the obvious benefits of focusing on alpha (flexibility for both investors and managers), the structure and business processes implemented at AP7 have other benefits according to the authors:
But re-writing the playbook brought new challenges. One was the requirement for new risk measures. As Grottheim and colleagues report:
The paper contains one example of an active long only manager with an apparent propensity for index-hugging. When the index was stripped from the return stream, it was found that the manager was actually producing a negative alpha (charts below).
While you’d think the market can be tracked perfectly by a passive investment, even the beta portion of the AP7 portfolio contained enough tracking error to leave an active footprint once the market was removed (right chart below), although things seem to be improving in recent years.
Grottheim says the search for alpha has been a bit tougher however. Apparently, managers have had trouble getting their head around the lack of any physical capital. Their longs and shorts are given life via overweighting and underweighting a separate passive portfolio - meaning they don’t actually manage any money. Managers are asked to construction an overlay as if they managed x Swedish kronor. That “x” is called the “notional amount”. Naturally, the changing the notional amount (the denominator in the return calculation) would dramatically change the return of the overlay. So you can see how things get a little weird. While there are technically no assets under management, compensation has ended up being a combination of both management and performance fees. In conclusion Grottheim makes the following observations about the transition at AP7:
Comments »Lending stock to yourself: nifty idea, but effectively just active long-only management?17 June 2008
The firm (”Enhanced Index Products Company” or “EIP”) was the subject earlier this week of a Reuters article that said the firm “is looking to triple its assets through a rare marriage of passive and alternative investing, creating market tracking index funds it can use to source stock for complex trades.” Essentially, EIP uses its much larger index funds as a source for the stock borrow required by the relatively puny long/short fund - a strategy to short-selling that the firm says is “ideal solution for markets where hedge funds can’t easily or cheaply borrow stock they need for their often sophisticated trading strategies”.
Comments »Silos, flesh wounds, the “disintermediation” of poultry, and a call to action4 June 2008More from London (see yesterday’s posting for background)… A pension plan as a financial services firm
It turns out that this view of the hedge fund portfolio as a sort of arm’s length asset manager with only one client can also be applied to the pension fund as a whole. That’s how one major private pension fund described it to a gathering here in London today – as a “financial firm that produces pensions.” This view also has implications for “liability-driven investing” (LDI). Some said that the process of liability-matching and return-enhancing should be kept separate within this financial services firm. For example, one major pension fund here created a team focused on removing interest rate and inflation risk (via a “matching portfolio” designed to match the plan’s future liabilities to pensioners) and a separate team focused solely on trying to squeeze additional returns out of those assets. In true arm’s length fashion, the “return portfolio” is required to literally borrow assets from the matching portfolio – creating a real economic incentive to beat the short-term rates charged on this internal loan.
Comments »Thomas Friedman on alpha/beta separation2 June 2008
Apparently, Thomas Friedman’s seminal book “The World is Flat” has a lot to say about the current state of asset management. Writes Rabovsky:
Comments »One of portable alpha’s originators says concept has evolved, in some cases, into something “vastly different”11 May 2008PIMCO’s Chris Dialynas knows portable alpha. In fact, commentators such as author Peter Bernstein generally agree that PIMCO essentially invented portable alpha back in the 1980s in the form of the firm’s “StocksPLUS” and “BondsPLUS” products (see related posting). Dialynas joined PIMCO way back in 1980 - surely before several of PIMCO’s current junior analysts were even born. So when he cautions the world about the movement he helped create, we’re probably best served by listening closely to what he has to say. He is the author of the epilogue to the new book “Portable Alpha Theory and Practice” by Sabrina Callin (see related posting). The chapter is ominously titled “Portable Alpha - The Final Chapter: Schemes, Dreams, and Financial Imbalances: ‘There Must Be More Money’” and it amounts to something of a sanity check on the current state of portable alpha. The entire chapter can be downloaded here at AllAboutAlpha.com. While cautious, Dialynas doesn’t actually question the underlying rationale behind alpha-beta separation or portable alpha itself. Instead, he expresses his concern that the techniques often used to create or isolate pure alpha (leverage and derivatives for example) have led to unacceptable risks to the financial system (think: Richard Bookstaber’s “Demons of Our Own Design” - see related posting). Says Dialynas:
Comments »Alpha-centric investing described as a “seismic shift”9 May 2008
Now the landscape is changing. Or perhaps more accurately, investors are now expressing a desire to try their hand at portfolio construction using basic ingredients such as cash, beta, and alpha. This FT article (”Equity fund outflows bring need to adapt“) is a must read for anyone who thinks we’re nuts. The newspaper describes the changes facing the asset management industry as nothing less than a “seismic shift”. Kevin Parker, the head of Deutsche Bank’s $800 billion money management business tells the FT:
The FT also cites Jim McCaughan, CEO of Principal Financial Group as an advocate of alpha-centric thinking:
Comments »“Portable Alpha Theory & Practice”: Exclusive chapter downloads at AllAboutAlpha.com8 May 2008
Impressed with what we saw in the book, we called up its author Sabrina Callin and have now arranged to provide you, the loyal AllAboutAlpha.com reader, with two of its chapters for free. Today, we give you chapter one - the introduction by Callin that provides a good summary of the entire book. And next week, we’ll post the Epilogue by Callin’s PIMCO colleague Chris Dialynas. But for those who are totally pressed for time, here’s a “summary of the summary” reflected by the chapter titles and a few key excerpts from chapter one:
Comments »Is “Active/Passive” another term for “Alpha/Beta”? Not quite.24 April 2008In December, we told you about plans for a new series of mutual funds constructed by combining active and passive components (see posting). Boston-based FundQuest had always been content to provide the plumbing for the mutual fund industry - manager selection, back office support, marketing services and sales support to financial advisors. But the firm announced last week that it has finally launched its first mutual fund based on these ideas- called ”ActivePassive Portfolios” (see sales brochure). While this sounds like an oxymoron, it’s a great example of alpha/beta separation extending slowly, but surely, into the retail marketplace. As a sort of pre-packaged alpha-beta solution, it reminds us of the Janus institutional offering launched last year (see related posting). Here’s what they say about the “optimal” ratio for the offering:
Comments »Start your alpha engines, “the race is on”23 March 2008
Hedge Funds “outperformed by a very handy margin” Of course, this convergence presupposes that these alternative asset classes actually represent something of value. And after racking up volatile results over the past 6 months, hedge funds, for one, are raising some eyebrows. Still, Merrill argues that recent performance does little to diminish the value of hedge funds:
This last point bears some reinforcement, we believe, because “bubbles” occur when investors bid up prices in a relatively short amount of time. As this report points out, the percentage of assets managed by hedge funds has grown rather slowly, they continue to represent less than 1.5% of global “mainstream” assets and their net asset values are based on underlying securities, not a subjective premium like, for example, tech stocks (see related posting).
Comments »Alpha-centric Newsreel14 March 2008
Morgan Stanley says Alpha/Beta Separation “the way of the future”. The AllAboutAlpha site partner lays out its alpha-centric philosophy telling IPE that the pension industry is about to experience a “second wave” of LDI strategies based on the separation of alpha and beta. Dutch Insurer Aegon splits portfolio into alpha and beta segments are farms each one out to a different manager. According to the firm’s press release, “By managing the parts separately from one another, better risk-return ratios are possible. This way, more sources of value added will be available and a greater focus can be created in the portfolio. Separating the US share portfolio has created an increase of a yearly average of the total return of 2.5% without any risk increase.”
Comments »Hedge Funds shouldn’t fear “The Blob”6 February 2008
He picks up on a theme espoused by his late colleague, Chet Currier in a December 2006 column on how mutual funds may someday become “obsolete”, when he observes:
But throughout the column he paints hedge funds with the same brush:
Comments »What do Ikea and maple syrup have in common?31 January 2008
According to Thomson, AP7 CIO Richard Grottheim has just selected what he calls “pure alpha European equity managers” - this, after hiring two ”pure alpha” domestic managers already this year. If these mandates pan out as expected, Grottheim says he will roll out the “pure alpha” strategy to Asia and emerging markets. So what exactly is this “pure alpha” shtick anyway? More than an empty marketing promise, the term is used by AP7 to describe a form of unfunded alpha overlay that uses proceeds from shorts to fund long positions - kind of like the “30/30″ portion of a 130/30 fund. Says Thomson:
Comments »Swedish Pension Plan: Alpha-Beta Split = Investment “Creativity”17 December 2007
According to Thomson Investment News, Morsing told the crowd:
AP2’s website contains more on the plan’s alpha-centric credentials, including this chart showing 2006 return contributions from alpha and beta sources:
Comments »Mutual fund company launches retail portable alpha funds based on “real” alpha3 December 2007
For several years now, academics and practitioners alike have questioned whether the alpha reported by hedge funds is ”real” or whether it’s just alternative or “exotic” beta. Yet it seems the mutual fund industry has been largely immune to such rigorous analysis. Once the influence of the market is removed from a mutual fund’s return stream, it is often assumed that what remains must be alpha. However, this alpha is no more “real” than the alpha produced by a market neutral hedge fund. Now Investment News reports that one mutual fund company has applied concepts such as “exotic beta” to the mutual fund industry. The result is a sort of packaged portable alpha solution for US retail investors:
The idea of pre-packaging alpha and beta in various, flexible combinations is the stock-in-trade of many funds of hedge funds (see related posting). But Investment News may be right that the mutual fund industry has never really embraced portable alpha-like solutions. FundQuest may have institutional investing in its blood, however. It’s owned by BNP Paribas, the mega-manager with deep institutional roots.
Comments »BGI: Why Buy Pre-Packaged Alpha & Beta?18 June 2007
When asked by Knab about the appropriate fee for true alpha, Becker’s provided a refreshingly frank answer:
Comments »Style Analysis: A Holding-Based Microscope or Return-Based Telescope?22 May 2007
This is clearly a “holding-based” approach to analyzing manager value-add that differs from the traditional returns-based approach which infers the make-up of a portfolio from the way it responds to exogenous variables. The return-based approach was, of course, first popularized by William Sharpe late last century (for modern examples of such detective work, see this Amaranth case study or this Fidelity Magellan case study). While return-based analysis is computationally easier, it has come under attack recently as a somewhat blunt instrument. In its place, the infinitely more granular holding-based approach has captured the limelight. To be sure, holding-based analysis is elegant and is being adopted by legions of funds of funds, and other institutional investors who have position-level transparency into the funds they own. But is it infallible?
Comments »Mommy, Where do alphas come from?15 May 2007
Thankfully, MIT’s Andrew Lo just released a new paper entitled “Where Do Alphas Come from?: A New Measure of the Value of Active Investment Management”. In it, Lo proposes a new way of measuring alpha that addresses this age-old question (hat-tip to The Beta Brief for calling the AllAboutAlpha tip line with this one). (Lo, by the way, scored his own chapter in Peter Bernstein’s new book Capital Ideas Evolving. Much more on this book in the coming days as we wade through it here at AllAboutAlpha.com world headquarters.) Traditional (CAPM) measures of active management have relied on the extent to which a fund is correlated to its benchmark. Then in 1992, William Sharpe took this notion a step further by regressing mutual fund returns against not just a fund’s own benchmark, but against several passive indices.
Comments »A quarter vs. three nickels and a dime…13 May 2007
Okay. So what? Well, this Vanguard article entitled “Alpha-Beta Separation: Appealing Theory, Problematic Reality“, begins with the familiar line “Would you rather have a quarter or three nickels and a dime?”, and goes on to describe alpha as the dime and beta(s) as the nickels.
Comments »Poll of institutional investors shows they face a "sea of ambiguity"9 May 2007
This interesting report reminds us of the enormity of this communication and education task. Consulting and advisory firm Strategic Investment Group sponsors a number of roundtable sessions involving institutional investors each year to discuss topical issues in the industry. They call this initiative the “National Strategic Investment Dialogue” (NSID) and its output is summarized in a report at the end of each year. While these annual reports are not available to the general public, NSID has allowed us to provide you the 2006 edition in full here. The 2006 Year in Review report finds that institutional investors are “…afloat on a sea of ambiguity”…
Comments »Alpha-centric Investing on Main Street25 April 2007
So to determine how these ideas are playing on “Main Street”, we look to Columbus, Ohio and Matthew Brandeburg a planner with John E. Sestina and Company, a fee-only planning firm. He writes in Financial Advisor that financial advisors can’t just look to the mutual funds they recommend to produce all the alpha. They too must produce the good stuff:
Comments »Bridgewater: Hedge fund leverage now at levels not seen since LTCM19 April 2007
The following excerpt succinctly sums up the philosophy shared by $100b+ Bridgewater and the somewhat smaller, but no less enthusiastic, AllAboutAlpha.com:
Comments »Janus: The Roman god of alpha/beta separation?25 March 2007
In fairness, the “face transplant logo” is actually a representation of the Roman god of new beginnings named - you guessed it, Janus (as in Jan-uary). If Modular Portfolio Construction catches on, Janus hopes it might someday be recognized as a new beginning for retail portfolio construction. Say the rocket scientists at “Janus Labs”:
Comments »Columnist throws out alpha baby with beta bathwater18 March 2007
But he has thrown out the baby with the bathwater in his latest critique of active management. Earlier this month, Currier referred to alpha as a “mirage”. His thesis:
Comments »Magellan a “Frankenfund”: Professor6 March 2007Stansky’s Monster: A Critical Examination of Fidelity Magellan’s “Frankenfund”
Yesterday’s posting discussed Fidelity’s desire to add performance fees to its lineup in order to address recent underperformance. Today, we cover one example of said “underperformance”: Magellan’s hard luck since the turn of the century. Fidelity’s Magellan is commonly cited for its extremely high r-squared to equity markets. In other words, it’s been an ETF in disguise. So who better to tell the story than Professor Ross Miller of SUNY Albany - a man whose paper on index hugging is in the Portable Alpha Hall of Fame. Miller released this ringing indictment of Magellan last month. It starts with an entertaining and easy-to-read history of the fund and its colourful managers - from Peter Lynch’s “ten baggers” (some sourced from his wife’s grocery preferences) to Jeffrey Vinik’s prematurely defensive positioning in 1996 to Robert Stansky’s closet indexing of the late 90’s and early part of this decade. But then Miller throws off the gloves:
Comments »Jaeger: Hedge Funds Usher in “Atomic” Age of Investing12 February 2007
Jaeger’s Partners Group has developed replication portfolios to mimic the performance of various hedge fund strategies. The returns of these replication portfolios actually beat all hedge fund strategies except distressed (which, according to Jaeger, contains a lot of alpha and is therefore difficult to replicate). Jaeger says that long/short managers, on the other hand, are particularly susceptible to replication.
Comments »Pyramis (Fidelity) Splices Alpha & Beta2 February 2007“Fidelity Targets Pensions Cash”
Note to pension readers: get ready for a call from your friendly neighborhood Fidelity sales guy. According to the Financial Times, Fidelity’s institutional arm, Pyramis, is about to teach a clinic on alpha-centric investing:
In fact, they are even planning to implement performance fees on some of their products (which makes a lot of sense - as long as the performance fees are based on alpha generated). Not surprisingly, one of its first forays into alpha-centric products will be a 130/30 fund:
Comments »The Future is “True Alpha” & “Cheap Beta”: McKinsey29 January 2007“The Asset Management Industry: A Growing Gap Between the Winners and the Also-Rans”
This McKinsey report echoes a theme discussed by Tim Price, the CIO of Global Strategies at UBP. It essentially concludes that is is the best of times and worst of times for asset managers. To back up this argument, McKinsey reports on a survey showing a widening disparity between the most profitable asset managers and the least profitable. Their research shows that, as recently as 2005, there was a 41% difference between the gross margins of the top third and bottom third of asset managers. The report continues:
Comments »Alpha/Beta Separation & Integration is #3 Trend for 2007: New Watson Wyatt Report26 January 2007“2007 Global Pension Assets Study” “Alpha/Beta Separation” isn’t just another pretty face. This year it’s listed third on Watson Wyatt’s list of the “Six Faces of Change” for pension investing. The “six faces” include:
Comments »UMAs: Base Camp for Wealth Managers to Scale Mt. Alpha10 January 2007“SMAs grow up and learn to play nicely in the advisory community”
UMAs allow an integrated approach to portfolio construction by streamlining reporting, tax management, and account administration from across several outside asset managers. In a truly “unified” UMA, managers deliver their models only (they do not technically manage the assets). Then the advisory firm implements the models and tweaks them where required to meet the specific tax or financial planning requirements of each client. In doing so, UMAs allow advisors to effectively integrate various alphas and betas (whether they be bundled in long-only accounts or isolated in market neutral hedge funds and ETFs). According to some, baby boomers desire a more active role in portfolio management. This creates a fertile ground for a more active approach to “managing managers”:
Comments »William Sharpe: Institutional Asset Allocation Studies “Inferior”20 December 2006
For those of you who don’t have a Nobel Prize or who have a Nobel Prize in an discipline other than Economics, don’t be turned off by the title of this book. Despite trying its best to scare people away with one of the driest titles in the history of publishing, this book is worth reading.
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With its (appropriate) focus on generating returns, the asset management industry tends not to spend inordinate amounts of time on introspection - on the way firms in the industry management and organize themselves. As management consults are fond of saying “form follows function”. That’s consulting-speak for “structure follows strategy”. 
Since May 2002, a Hong Kong based enhanced index fund manager has been essentially lending stock to itself to create short positions in its long/short equity fund. The result has been a portfolio architecture that one usually finds only at the largest, most sophisticated institutions.
As some pension funds begin to shift from funds of funds to single-manager hedge funds, they usually create what amounts to their own internal fund of funds. The only difference between this fund of funds and a “real” fund of funds is that the pension has only one client: its own pension plan. 
Watson Wyatt consultant Janet Rabovsky passes along 
We have always argued that actively-managed mutual funds are essentially a marketing package for two fundamentally different formations: a large deposit of beta and a vein of pure alpha. Unable to travel either the peaks and valleys of beta or the undulating topography of pure alpha, mutual fund companies long ago found a neutral territory that seems to have satisfied investors worldwide for over 50 years.
Last week, 
In a 
Here is a sample of the news stories we didn’t get a chance to explore in detail this week. As usual, all of them can be found on the Alpha-ticker above or in the news items section of AllAboutAlpha.com (free registration may be required for a few of these).
Bloomberg Columnist Michael Sesit 
The 80 billion Swedish krona Sjunde AP7-foden (”AP7″) public pension fund might as well be called the “Alpha-Pure” fund. Last year, the fund made a splash by re-organizing itself along alpha and beta lines and this week, one executive tells Thomson Investment News that the quest for “pure alpha” continues. 
This month’s alpha-centric ”fan-of-the-month” award goes out Tomas Morsing, head of quantitative strategies at the 24 billion Euro Swedish public pension, AP2 (one of several ”buffer funds” serving the nation’s citizens). Morsing addressed the London edition of Terrapinn’s 
Can you spot a fake? 
With the release of Andrew Lo’s recent paper on a new way to calculate alpha, 
Ah, the question every parent dreads. Where do alphas come from? How can you possibly explain such a complex and miraculous process that has given life to asset managers since time began?
Does anyone remember the series of fake commercials on Saturday Night Live in the late 1980’s for the “First Citiwide Change Bank”? (click 
The benefits, costs and risks of 130/30, portable alpha, hedge funds and other emerging investment techniques are now quite clear to those immersed in the hedge fund and asset management community. As we debate abstract ideas such as market inefficiencies, it’s easy to become frustrated with the pace of adoption. But the fact remains that communicating these ideas to a broader audience of investment committees and advisers remains a critical step in the gradual acceptance of alpha-centric investment techniques.
While we argue that alpha/beta separation will have a broad-ranging impact on the world of asset management, we are often hard-pressed to find articles or papers written by or for financial advisors. However, 
As regular readers know, we are big fans of Bridgewater Associates. Their quintessentially “alpha-centric” view of the world amounts to a case study in modern portoflio management. The firm put out an interesting note in January that was recently brought to our attention by blog wonderkid Yaser Anwar over at 
Janus, the company whose logo looks like an early version of that face transplant performed in France last year, has come out with an intriguing offering that aims to separate alpha and beta investment decisions. It’s called “
Bloomberg’s Chet Currier is generally in tune with alpha-centric investing. In a 
By: Ross Miller, State University of New York (SUNY), Albany
You don’t need a Ph.D. in physics to understand hedge fund replication. But Lars Jaeger has one just in case. And he used it masterfully today to draw an analogy between the model of the atom in the 19th century (a random mass of various particles) and the common paradigm understood today including a nucleus (containing most of the atom’s mass) and a number of electrons orbiting it. Until now, he argues, hedge funds have been viewed as a random mass of alpha, beta and error terms. But a new paradigm is now emerging that aggregates betas into a “nucleus” orbited by various alphas. The same could be said for active long-only investing in our view. Until now, long-only management has also been a mass of alpha and a set of betas (dominated by market beta).
By: Deborah Brewster, Financial Times
By: McKinsey & Company
By: Watson Wyatt
While institutional investors have been busy debating the merits of bifurcating alpha and beta, the wealth management industry has inadvertently stumbled upon an enabling technology that may someday bring alpha-centric investing to the masses. New information technologies are allowing Separately Managed Accounts (SMAs) to evolve into fully integrated Unified Managed Accounts (
Alpha Male has just finished reading William Sharpe’s new book, “