July 15, 2013
Is Beta Just Alpha Waiting To Be Discovered?
What differentiates Hirtle Callaghan from the rest of the investment community is our ability to determine when and to what degree we are deploying capital at the strategic level. The importance of strategic asset allocation has been well known and well documented for quite some time1. However, once strategic policy allocations have been decided upon, many investors rely on manager selection as their single source of value-add. It isn’t clear why this is so, given that most investors destroy value in the manager selection process, however this Bayesian rigidity may derive from Investment Committee turnover, self-attribution bias, a lack of a clear and repeatable allocation process and perhaps the business challenge of scaling client customization.2 Nevertheless, many investors spend a majority of their time, effort and research on the decisions that matter least. Investors would be better served by continuously challenging and updating the assumptions which underlie their strategic allocations. We believe our fundamental advantage begins with our belief that portfolio allocations should adjust as valuations within the opportunity set change. As asset class risk premiums change, we determine where clients are being best rewarded to assume appropriate levels of risk and adjust portfolios accordingly. Thus, our alpha, we believe, is partly due to our ability to identify, value, and allocate to beta.
Presented with the opportunity to invest in an active manager whose style can be replicated by a passive beta strategy, all else being equal, we would choose the passive style portfolio. Why pay active fees when you can get a similar portfolio at index pricing? On the flip-side, when true-alpha can be identified, we are more than willing to pay for that skill (only at the right price!). The reality is, however, more and more alpha generating strategies can be replicated through passive means. One of the best pieces I have read on this topic, "Is Alpha Just Beta Waiting To Be Discovered", Berger, Kabiller and Crowell discuss this trend within the Hedge Fund universe.3 Even in a space known for skill and alpha generation, certain strategies, they argue, can be replicated systematically. At some point, when sources of alpha can be replicated passively, they will represent a new beta. This trend has manifested itself in the explosion of custom indexing strategies across the institutional landscape. While some investors view these strategies as competition, others, Hirtle Callaghan included, view these strategies as a potential source of value add for our clients, from the perspective of lower fees, better risk management, and modeling predictability.
The long-term implication of this trend is that investors who are ill-equipped to value strategies on an individual basis have a new tool to chase returns and destroy value. We may see a day when a portfolio is implemented entirely through passive means, however, without a reduction in aggregate tracking risk or potential for value add. As more and more strategies become available through passive means, the importance of a dynamic asset allocation will become even more important. As CIOs, the critical question we must ask regardless of implementation style is which mix of betas has the highest likelihood of achieving objectives. The answer to that question will change over time, and so will our portfolios. We believe the ability to adjust portfolios based on changing risk premiums is a more consistent, repeatable approach to adding value at the portfolio level and a unique competitive for Hirtle Callaghan.
1) Gary P. Brison, L. Randolph Hood, and Gilbert L. Beebower, Determinants of Portfolio Performance, The Financial Analysts Journal, July/August 1986.
2) Amit Goyal, Sunil Wahal, The Selection and Termination of Investment Management Firms by Plan Sponsors, The Journal of Finance, August 2008.
3) Adam L. Berger, David Kabiller, and Brian Crowell, Is Alpha Just Beta Waiting To Be Discovered?, AQR Capital Management, Summer 2008
Mike A. Pagliaro, CFA
Mike is an Investment Officer with Hirtle Callaghan and works with the firm’s institutional clients. Prior to joining Hirtle, Callaghan & Co. in 2008, Mike worked most recently for Cohen & Company where he was an Associate within the firm’s REIT team, and earlier for SEI Investments where he was a member of the firm’s Investment Management Unit. Mike earned a B.S. from St. Joseph’s University and an M.B.A. from Bentley College. He is a CFA charterholder and a member of the CFA Institute. He currently holds a Series 65 license.