Dissertation - Tom Oor - Portable Alpha, Quo Vadis

8/4/2019 Dissertation - Tom Oor - Portable Alpha, Quo Vadis

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Portable Alpha at Dutch Pension Funds, Quo Vadis?

An assessment of its application, impact and relevance

by

Tom Oor

2007

Masters Dissertation

Dissertation submitted in accordance with the rules of

TiasNimbas Business School

in partial fulfilment of the requirements for the degree of

MSc in Financial Management


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TiasNimbas Business School

ELECTRONIC DISSERTATION DEPOSIT AGREEMENTSeptember 2007

Student name: Tom Oor

Student ID: 200652026

Degree: Master by Advanced Study

Dissertation Title: Portable Alpha at Dutch Pension Funds, Quo Vadis?


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Student Signature:

Date: 8 September 2007


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STATEMENT OF AUTHENTICITY

I have read the TiasNimbas Business School

Regulations relating to plagiarism and certify that

this project is all my own work and does not

contain any unacknowledged work from any other

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I confirm that the Word Count as per the

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Date: 8 September 2007


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KEYWORDS AND ABSTRACT

Name: Tom Oor

Title: Portable Alpha at Dutch Pension Funds, Quo Vadis?


Keywords

Portable Alpha Alpha Investing portfolio optimization

Market Inefficiencies Dutch Pension Funds Alpha

Portfolio Investment Overlay strategies Asset Allocation strategy

Abstract

This dissertation examines the relevance of portable alpha for Dutch pension funds. The

researchs principal purpose is to define the boundaries of relevance for the concept in

general and in a Dutch context. Subsequently, the aim is to reveal the inherent

limitations of the concept and to expose the hurdles to manage and monitor the concept.

The extensive literature review grounded the concept in a solid academic framework

and exhibited the boundaries of relevance for the concept, the difficulties for applyingthe concept in an organisational context and the dissimilar relevance for individual

pension funds. The results from the literature reviews were used to form a rudimentary

idea of the broader concepts forming the concept and attempted to avoid projecting the

authors thoughts upon the interviewees. Subsequently, interviews were held with a

mixture of eminent practitioners and academics to provide empirical evidence.

The research revealed that portable alpha in contrast to the conventional approach is a

valuable contribution by allowing for separating alpha and beta decisions in which the

alpha and beta portfolio can be optimized for their distinct means. Nevertheless,

portable alpha has limitations having to exclude alpha sources and the difficulties to

manage and monitor such a complex process. Furthermore, dissimilar pension fund

organisational capabilities revealed that portable alpha is not (yet) suitable for all

pension funds.


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PREFACE

Fascinated by the intricate investment environment in which Dutch pension funds have

to operate, in combination with being the son of an actuary and thus exposed to long

diner discussions about developments at Dutch pension funds, I directed my efforts to

search for an actual investment issue at Dutch pension funds.

After a long quest of searching a subject that would justify a real knowledge gap in

terms of academic knowledge and that moreover would be the crowning glory of my

last academic year, I arrived at portable alpha. The notion portable alpha appeared to be

a well debated issue at the investment industry. However, peculiarly the concept was

devoid of an extensive academic body of literature and the predominant focus was on

explaining the function of portable alpha. This dichotomy aroused the interest to

examine the stance of portable alpha amongst Dutch pension funds and the relevance

for them.

No dissertation is solely the effort of the author and this dissertation is certainly no

exception. I am grateful to all those whom assisted me in the culmination of my last

academic year in the form of this dissertation. In particularly to my father for his ability

to clarify hot-debated pension fund issues and without whose help selecting appropriate

interviewees would have been almost an impossible task. Furthermore, I would like to

express my gratitude for the willingness of the interviewees to participate in my

dissertation and share their viewpoints on portable alpha and investment practices. Also,

I sincerely appreciated the gesture of Mr. Larry Siegel and Mr. Rob Arnott for sending

me their publications. Last but not least, I am thankful to my supervisor guiding the

advancement of my dissertation in hopefully the proper direction and providing

adequate support.

Tom Oor

Utrecht, 8 September 2007


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I devote this dissertation to my grandparents, for their eternal support and understanding


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TABLE OF CONTENTS(Condensed)

Keywords and abstract IV

Preface V

Table of contents (condensed) VII

Table of contents VIII

List of figures XII

Part I Introduction 1

1 Overture 2

2 Research methodology 8

Part II Literature Review 16

3 The underlying creed 17

4 Active management: the quest for alpha 23

5 Portable Alpha 35

Part III Research Analysis 48

6 Analysis of the in-depth interviews 49

7 Findings and discussions 65

8 Conclusions and recommendations 72

Appendices 77

References 107


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TABLE OF CONTENTS

Keywords and abstract IV

Preface VTable of contents (condensed) VII

Table of contents VIII

List of figures XII

Part I - Introduction 1

1. Overture 21.1.Background 21.2.Aim 41.3.Research Question 51.4.Research Objectives 51.5.Scope 51.6.Research Contribution 61.7.Dissertation structure 6

2. Research Methodology 82.1.Research Purpose 92.2.The Initial Conceptual Framework 92.3.Research Philosophy 102.4.Research Approach 112.5.Research Strategy 112.6.Literature Review 122.7.Primary Research 12

2.7.1. Elite Interviews 122.7.2. Interview Structure 13

2.8.Analytical progression 132.9.The Soundness of the Research 14

2.9.1. Reliability 142.9.2. Construct Validity 152.9.3. External Validity 15

Part II - The Literature Review 16


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3. The Underlying Creed 173.1. Markowitz 173.2.The Capital Asset Pricing Model 183.3.The State of Market Efficiency 213.4.Conclusions 22

4. Active Management: The Quest for Alpha 234.1.The Domain of Active Investing 234.2.Market Risk and Active Risk: Unconditional Rewards and Conditional

Rewards 24

4.3.Alpha Returns: The Alpha Universe 264.4.The (Human) Skill Factor 274.5.The Benchmark 294.6.Measuring Investment Performance 304.7.Alpha Performance Constraints 314.8.The cost of the Quest for Alpha 324.9.Building active portfolios: Maximizing Alpha Returns 324.10. The Value Addition of Alpha 34

5. Portable Alpha 355.1.The Concept 355.2.The Portable Alpha Approach versus the Traditional Approach 365.3.The Conceptualization in Depth 40

5.3.1. An Optimal Alpha Source 405.3.2. Restriction to Alpha Sources 415.3.3. Derivative Overlay: Alpha Decomposition 425.3.4. Derivative overlay: The Inherent Difficulties 44

5.4.The Portable Alpha Extent 455.5.Portable Alpha Management: The Operational Procedures 455.6.Portable Alpha in a Contemporary Context 46

Part III Research Analysis 49

6. Analysis of the In-depth Interviews 506.1. Portable Alpha at the Dutch Pension Funds 50

6.1.1. Scepticism towards New Investment Products and Strategies 526.1.2. A Radical Change in Mindset 52


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6.1.3. Difficult to Manage Portable Alpha 536.1.4. The Sustainability of Alpha 53

6.2.The Relevance of Alpha: The Situational Context of Portable Alpha 546.2.1. Alpha Investing at Dutch Pension Funds 546.2.2. The Alpha Contribution to Portfolio Returns 556.2.3. Portable Alpha Remains Subject to Classic Alpha Investing Difficulties

57

6.3.Conceptual Findings 576.3.1. Non-Conventional Asset Categories 586.3.2. The Portable Alpha Manager 58

6.4.Portable Alpha: A Portfolio Division in Alpha and Beta Portfolios 586.5.The Asset Allocation Argument: Decoupling Alpha and Beta 606.6.The Conceptual Framework: Relating the Variables 61

7. Findings and Discussions 657.1.Consensus on the relevance of portable alpha remains unattained 657.2.The relevance of portable alpha is found in the contribution of alpha to

pension fund portfolio returns 67

7.3.Practical limitations to the theoretical concept have been identified 697.4.The applicability of portable alpha depends upon the organizational context

of a pension fund 71

8. Conclusions and Recommendations 728.1.Conclusions 728.2.Recommendations for Further Research 758.3.The Research Process in Retrospect 75

Appendices 77

Appendix I - Dissertation Proposal 78

Appendix II - Profiles Interviewees 93

Appendix 3 - Elite in-depth interview results 94

References 107


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LIST OF FIGURES

Exhibit 2.1 Methodology Structure 8

Exhibit 2.2 Initial conceptual Framework 9Exhibit 3.2 The Capital Asset Pricing Model 18

Exhibit 3.2.1 Graphic display of alpha performance 20

Exhibit 4.2 Alpha and beta risk aggregation under similar risk aversions 25

Exhibit 4.2.1 The real impact of aggregating alpha and beta risk 26

Exhibit 4.9 Efficient Frontier of Alpha Managers 33

Exhibit 5.1 The portable alpha concept 36

Exhibit 5.2 Conventional portfolio approach 37

Exhibit 5.2.1 portable alpha approach 38

Exhibit 5.3.1 The Alpha Continuum 40

Exhibit 6.2.2 The Contribution of Alpha to portfolio investment 56

Exhibit 6.7 The conceptual Framework 64


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Part I

Introduction

Part I functions as an introduction to the dissertation. Chapter 1 elaborates on the

rationale for undertaking the research, the aim and scope of the dissertation.

Subsequently, in chapter 2 the research methodology in descending order flowing from

the general to the specific is being discussed.


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1. OVERTUREThis first chapter serves as a synopsis of the dissertation. First the background of the

dissertation is dealt with to provide the rationale and justification for undertaking the

research. Based upon these rationales, the aim, objectives and central question of the

research are specified. Hereafter, the scope of the research is displayed and lastly, the

dissertation structure is clarified serving as a guideline for the reader.

1.1.BackgroundModern thinking about the domain of investment is largely influenced by the invaluable

grand theories of Markowitz (1952), Sharpe (1964) and Fama (1970) that revolutionizedthe world of investments. Their respective theories form the foundation for our

assumptions and perceptions of the world of investments. Within this context, new

investment concepts emerge and submerge attempting to enhance portfolio investment

performance.

Portable alpha is one of such contemporary arising conceptualizations. It attempts to

enhance portfolio investment by adding low correlated sources of return (Alpha) to a

portfolio whilst maintaining the combined portfolios desired systematic (Beta)

exposure (Coates and Baumgartner 2006). Thereby it provides the ability to decouple

alpha and beta resulting in the ability to optimize alpha for incremental returns and beta

for asset-liability matching.

Theoretically speaking, portable alpha is appealing as a valuable concept for portfolio

investment by institutional investors, especially pension funds. Implementing a portable

alpha concept might lead to optimizing alpha returns in portfolio context and the ability

to provide a matching portfolio and a return portfolio. Therefore, portable alpha might

enhance portfolio performance in the aforementioned ways. The dissertation and the

underlying rationales for undertaking the research are founded upon a line of reasoning

that has practical as well academic significance.

First, the proliferation of conferences on portable alpha, the myriad of publications and

the large number of consulting firms offering services around portable alpha serve as atestimony for the traction it has gained amongst business practices. However, a


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consensus about the relevance of portable alphas has not yet been attained. Business

practices and their stances on portable alpha are roughly subdivided into two camps: the

sceptics questioning the elusiveness of alpha itself and those who are beholding an

incremental implementation amongst institutional investors, and thus supporting the

relevance of the concept.

Secondly, much of the work to date is targeted at a practitioner audience and though

intuitively appealing, is not substantiated by an extensive body of academic research,

vetting the notion of portable alpha. Levy (1999) and Kung and Pullman (2004) are one

of the rare few who discuss the processes, benefits and drawbacks of Portable Alpha,

nevertheless tend to remain on the surface.Fung and Hsieh (2004) discuss the

conduciveness of long/short hedge funds as a source of extracting alpha for portable

alpha. Arnott (2002) makes a valuable contribution by manifesting how portable alpha

allows for the risk budget to be most effectively optimized and alpha be maximized.

Academics have forayed into the field of portable alpha but academic research related to

the subject remains in its infancy. The interest the concept has gained amongst business

practices and the lack of substantial academic literature could either be due to unilateral

development of the concept and thus a lack of interaction between academics and

practitioners or academic research still has to pick up on the concept.

Thirdly, portable alpha has gained momentum amongst institutional investors due to its

appealing features of providing leeway to asset allocation whilst generating alpha from

the panoply of different alpha resources. Recent developments in Dutch accounting

rules and regulatory requirements have further narrowed down the scope for risk

tolerance and investment possibilities. These phenomena have forced pension funds to

embrace liability driven investment (LDI) by investing in financial assets that match

their liabilities (Pensioen en Verzekeringskamer 2004; OECD 2005). Nonetheless

harmonizing liabilities with fixed income or index linked bonds reduce exposure to

interest rates and inflation but do not yield the returns to pay pensions. Portable alpha

has become the panacea for adhering to these stringent accounting and regulatory rules

and narrowing down the mismatch between assets and obligations and the ability to

provide incremental returns. Hence, it would be worthwhile to investigate whether

portable alpha contributes to such an intricate investment environment.


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Fourthly, the Netherlands with its well developed pension fund infrastructure and strict

legislative framework is an interesting setting to explore the relevance of portable alpha.

The industry has a large sample of pension funds differing in size of asset under

management, funding policies and investment policies. Furthermore, the Netherlands

includes a large segment of large pension funds which are probable to operate at the

frontiers of knowledge and thus capable to provide empirical evidence to portable alpha.

The combination of these factors influencing the sample is purposeful for analysing

portable alpha from a wider perspective.

Ultimately, Dutch pension funds have the largest relative amount of assets in terms of

Gross Domestic Product (GDP) under management (OECD 2005). Vetting portable

alpha and the relevance might lead to an enhancement in investment performance. In

the Netherlands such as a contribution would translate immediately into economic

development as the pension system applies to the entire population.

1.2.AimThe fundamental aim of the dissertation is to shed light on the relevance of portable

alpha for investment policies at Dutch pension funds. By doing so, it attempts to vet the

concept through a rigorous academic framework and explore until which extent the

theoretical conceptualizations of portable alpha add value to investment policies at

Dutch pension funds.

A sub aim is to reveal the differences between the theoretical concept and practical

implications. The complexities inherent to portable alpha might impose difficulties upon

the management and monitoring of the concept. The attempt here is to demonstrate the

limitations from an organisational point of perspective to embrace the concept.


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1.3.Research QuestionWhat is the relevance of portable alpha for the large Dutch pension funds?

1.4.Research ObjectivesThe research question functions as the central guideline for the research and is

subdivided into research objectives to concretize and provide support for the central

question. The following research objectives are pursued:

To investigate the implications, particularities, difficulties and usages of portablealpha from the viewpoint of investment consultants, practitioners and

academics;

To reveal the relevance of portable alpha in an organisational context at Dutchpension funds;

To explore the extent to which portable alpha might contribute to enhance Dutchpension fund investments;

To examine what the impact of portable alpha is on conventional portfolioinvestment management at Dutch pension funds.

1.5.ScopeA dissertation cant impossibly be exhaustive; therefore the scope for the research has

been limited allowing for focus. The sample for collecting empirical evidence is limited

to Dutch pension funds subject to the Dutch regulatory framework. Therefore Dutch

pension funds that have moved to nations in the European Union with a less stringentregulatory framework are excluded. Pension funds, in particularly the ones having

larger amounts of assets under management, might obtain advice about their investment

policies from foreign advisors, empirical data focuses solely on industry experts located

domestically. Furthermore, the focus is principally on qualitative information and

quantative information serves a secondary illustrative purpose.


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1.6.Research ContributionThe contribution of the dissertation is bivalent and therefore has as well academic value

as value for practitioners. The academic value is added by demonstrating how the

applied concept of portable alpha, emerging from the practitioners field of finance andinvestment, relates to the financial economic theories. This in contrast to the current

academic evidence on portable alpha that predominantly remains in the explanatory

phase grounds the conceptualization and demonstrates the boundaries of relevance.

Thus, the research interweaves portable alpha in an academic framework and appends

knowledge to the existing academic body of knowledge on portable alpha.

Pension funds contemplating more advanced investment strategies have an objective

insight in the relevance of the concept and are thus more able to discharge fallacies or

false claims by the investment industry. Furthermore, by exposing the obstacles of the

concept in organisational context pension funds can weigh in mind if their pension fund

is subject to these limitations and if a portable alpha strategy is worthwhile in

comparison to their actual investment policy.

1.7.Dissertation StructureThe dissertation is structured according three parts which are subdivided into chapters.

Firstly, Part I introduces the aim of the dissertation and the rationale for undertaking the

dissertation. Chapter 2 defines the research methodology and the reasons behind opting

for the particular methodology.

Secondly, Part II encompasses the literature review exposed as a narrative advancing

from the abstract to the specific commencing in chapter 3 with the cornerstones of

modern finance. Subsequently, advancing to chapter 4 exploring the particularities of

the domain of active investing and ultimately arriving at chapter 5 in which the impact,

relevance and limitations of portable alpha is discussed.

Lastly, Part III focus on the analysis of the research commencing in chapter 6 with

displaying the results obtained in the interviews. Chapter 7 synthesizes the findings

from the literature review with the results obtained in the empirical research. Chapter 8


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finalizes the dissertation by drawing conclusions based upon the synthesis in the attempt

to answer the central question of the dissertation.


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2. RESEARCH METHODOLOGYThis chapter describes the research process in a coherent narrative demonstrating how

the research proceeds from the initial research purpose to the final stages of conclusions

to answer the researchs question and objectives. These stages are all interlinked andproceed in a descending order of abstraction (see exhibit 2.1).

Exhibit 2.1- Methodology Structure (author)

The aim of this chapter is fourfold:

Firstly, to reflect on the different philosophical stances and to demonstrate thenexus between the philosophical approach chosen and the research process.

Secondly, to describe the methodological approach chosen and the resultingresearch design.

Thirdly, to describe the application of the research strategy in how we will goabout answering our initially stated research questions.

Fourthly, to demonstrate how the results from the research strategy will betransformed from raw data through the process of abstraction to the concluding

theory.

Research purpose

Research philosophy

Research approach

Research strategy

Analytical progression


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Last, reflecting on the methodology in the acknowledgement of its limitations.2.1.Research Purpose

The purpose of the dissertation is to identify the relevance of portable alpha in a Dutch

pension fund setting. The investment concept of portable alpha is vetted for its

theoretical contributions for pension funds in general and applied to a Dutch setting to

obtain the stances of academics and practitioners. By doing so the dissertation attempts

to separate the wheat from the chaff, i.e., resulting in an assessment of the limitations

inherent to the concept and the (prospective) contributions to Dutch pension funds.

2.2.The Initial Conceptual FrameworkIn the view of Huberman and Miles (1994):

Any researcher, no matter how inductive in approach, knows which bins are

likely to be in play in study and what is likely to be in them.

Therefore an elementary conceptual framework is formed and displayed graphically to

show how the initial thoughts about the research and interrelations about the concepts

were developed (see exhibit 2.2). The revelation of initial thoughts clarifies the initial

stance of the researcher towards the research process and manifests how these initial

thoughts lead to the formulation of the dissertation objectives.

Exhibit 2.2 Initial conceptual Framework (author)

Scepticism towards investment

industry claims

Portable alpha and beta suitable

for matching and incremental

return purposes

Theoretical difficulties inherentto portable alpha were well

known

Portable alpha in contrast toconventional approach liberates

the uest for al ha

The usage of derivatives

The management and monitoring

of constantly changing factors inortable al ha

Sustainable alpha remains

questionable

Allegations investment industry

about the relevance of portablealpha

Scarce academic literature onportable alpha predominant

ex lanator focus

Initial stance author


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2.3.Research PhilosophyAs Butterfield (1957) remarks:

Knowledge is not handed down to us by some super-human source but is

developed by the application of the human intellect.

Therefore the most abstracted idea about research originates in the human mind and is

determined by its philosophy towards the development of knowledge through research

(Remenyi 2002). This philosophical stance clarifies the researchers perception of the

worlds being and existence and defines how the study of knowledge should proceed to

capture the perception of truth.

Research philosophies are often represented by a polemic of two extremes: positivism

and interpretivism. A positivistic approach is characterized by Easterby-Smith et al

(1997) as the idea of a social world existing externally, objective and its properties

should be measured through objective methods inferred subjectively. Interpretivism

holds that only phenomena exist and therefore scientist should only study phenomena

and the related human experience to understand and explain why people have different

experiences and meanings.

Both ontological stances are widely debated for their perceptions of the nature of the

world and the applicability of the methodologies derived from these stances. Although

as Saunders (2003) properly remarks that the strength in acknowledging these

philosophical stances lays not within claiming superiority for one of these approaches

but the fact that these philosophical stances are more appropriate for different objectives

and research questions. In addition, Saunders (2003) remarks that practical reality,

especially in business research, is often a mixture of both.

The preferred philosophical stance for the dissertation is realism as it agrees that these

research philosophies are not mutual exclusive and a hybrid of both stances could

enrich and strengthen the results of the dissertation. Given the exploratory nature of the

dissertation illustrated in the initial conceptual framework and the derived objectives,

the dissertation inclines strongly to a subjective stance to gain insights through words

and meanings retained in a holistic view rather than figures to discover the relevanceinherent to a positivistic approach. Nevertheless, to quote George Homans (1949):


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People who write about methodology often forget that it is a matter of strategy,

not of morals.

2.4. Research ApproachThis chapter reflects the process of developing theory throughout the dissertation. In the

strictest sense, theory development can be contrasted by either the approach of having a

structured process with a pre-existent framework proceeding in a linear mode versus a

more unstructured approach based upon rudimentary ideas about the research which are

refined during the research process. Here again Saunders (2003) notes that these

approaches are not mutual exclusive. The dissertation inclines strongly to the

unstructured approach, based upon the following idea of reasoning:

The literature review on portable alpha revealed that the concept had not been properly

vetted by academics and was lacking a solid framework depriving the research approach

from grounding the notion theoretically with a high degree of reliability and thus

hampering to impose a definitive framework to derive hypotheses. Consequently, this

lack of rigour and objectivity at the outset lead to a less structured approach to shed

light on the relevance as one advances doing research. This unstructured approach is

more likely to yield a holistic view on all factors adding or detracting from therelevance of portable alpha and thus is likely to capture the entire scope of relevance of

portable alpha.

The dissertation inclines strongly to an unstructured approach, although not entirely as

such an approach lacks initial direction in which everything looks relevant at the start of

the research. Such a research purposes may lead to a protracted process of data

emerging beyond the time scope of the dissertation and bears the risk to be unable to

arrive at conclusions. To prevent this initial structure is provided by the literature

review parts of grand financial economic theories and the domain of alpha investing.

2.5.Research StrategyThe research strategy is the turning point where the philosophical stance and theory

development stance is translated in a hands-on approach of how you will go about

answering your research question and objectives and eventually inducing to

conclusions.


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The research strategy is not expressed in terms of a generic research strategy but

according the purpose of the research and as Robson (2002) endorses this is even

considered advantageous as these generic research strategies are not mutual exclusive.

To re-emphasize the aim of the dissertation is exploratory seeking to find out new

insights on portable alpha and hence the following exploratory research strategy is

formulated to answer these set objectives:

2.6.Literature ReviewThe literature review forms the foundation for setting the thesis for the research which

will serve as the initial input for the empirical research. This foundation is performed in

descending order of abstraction commencing with the deeper underlying economic

theories of finance and investments and eventually arriving at the scarce literature on

portable alpha. This assures to put portable alpha in a holistic finance and investment

perspective and at arrival at the literature review of portable alpha, these sources lacking

peer review can be contrasted to the preceding literature reviews and thus increases

reliability.

2.7.Primary ResearchFollowing the secondary research, the primary research focuses on the collection of

empirical evidence to gain an understanding of the relevance of portable alpha. It adopts

a qualitative approach by means of elite in-depth interviews. According Saunders

(2003) such an approach provides the ability to reveal perceptions and underlying

meanings of experiences from influential and well-informed individuals in an

organization based on their expertise (Marshall and Rossman 1995). Such a strategy is

preferred as these elite individuals are most probable persons to have an insight in the

relevance of portable alpha maximising theoretical depth for the given time constraints

of the dissertation.

2.7.1. Elite InterviewsThese elite interviews are conducted with the most influential persons in the Dutch

pension fund industry who are most likely to raise understanding in the complex

processes of portable alpha. The interview consists of a mixture of fiduciary managers,


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Chief Investment Officers (CIO) of pension funds, external investment consultants and

academics (see appendix 2). In our case, one can not study intensively and in depth all

large pension funds and thus the interviews are restricted to a particular population. This

implies that the sample is not taken to be reflective for the pension fund industry but

that depth is preferred over width. The Achilles' heel of qualitative research, subjective

bias, is minimized by triangulating perspectives from a variety of different sources.

In addition, theoretical saturation should be achieved at 6 in-depth interviews, although

a larger sample would be preferable, although to get access to these persons is a

daunting task. Marshall and Rossman (1995) endorse this difficulty and allege that these

elite interviewees are busy individuals, less willing to participate in a dissertation and

thus making it challenging to get these individuals to consent for cooperation.

2.7.2. Interview StructureThe exploratory nature of the research favours an unstructured approach preventing to

impose ones own preconceptions upon the interviewees and let the issues emerge from

the interviews (Maylor and Blackmon 2005). This does not imply that the interview is

an unorganized and non-directive approach but rather that space for anticipation and

flexibility is retained to obtain full depth. The ideas obtained in the literature review

form the foundation for in-depth interview and functions as a basic guide line

throughout the interview. Research questions derived from unreliable literature sources

are likely to enforce a biased reflection of portable alpha on the interviews.

2.8.Analytical progressionAfter having conducted the interview, the interview data follows a process to be

transformed in final conclusions by a logic sequence of analytical progression. Data

analysis in a qualitative approach does not proceed in a linear fashion and it is messy,

ambiguous and time consuming process weaving back and fourth between data

collection and analysis to ground theory. Nevertheless, the aim here is to provide

transparency by demonstrating the process of raw data transformation into conclusions

and recommendations. For this process, the ladder of analytical abstraction from Carney

(1990) is utilized and adjusted to the approach at hand:


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(1)Transforming interview tapes into written form(2)Transforming the written raw data into pure raw data by excluding irrelevant

information

(3)Identifying themes and patterns in the interviews(4)Cross checking tentative findings(5)Synthesis: integrating the thesis and antithesis into an explanatory framework

2.9.The Soundness of the ResearchAs Lincoln and Guba (1985) notes:

All research must respond to canons that stand as criteria against which the

trustworthiness of the project can be evaluated

To judge the quality of the research strategy Yins (2003) criteria are applied to the

methodology. These criteria are adjusted for their relevance in the chosen research

strategy.

2.9.1. ReliabilityThe strength inherent to qualitative research is to reflect contemporary reality of a

concept in its situational context by adopting a flexible approach to fully gain a holistic

insight of the concept. As reliability in the meaning of statistical generalization is not a

mean by itself for qualitative research, fostering reliability has only been allowed in

case of not undermining the qualitative approach.

Reliability is fostered through the usage of principally academic journals serving as

input for the interviewees who are all practitioners or academics with a strong track

record. Furthermore reliability is strengthened by preventing the occurrence of biases.

The interviewer appears properly dressed to convey a serious impression which is likely

to yield serious responses. Secondly, information about the research and purpose are

sent a few days prior to the interviews allowing for preparation for the interview.

Thirdly, the in-depth interview will be recorded by a memo recorder in consent with the

interviewee to retain the richness of the information provided.


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Lastly, the dissertation has focused on strengthening reliability by providing

transparency in the form of openly displaying the research process commencing with

the initial conceptual framework advancing through the ladder of abstraction into

conclusions about the research.

2.9.1. Construct ValidityThe methodology ascertained that the purpose of the research is properly translated

from the general into a specific method covering the aim of the research. Accuracy is

improved by setting up a strong academic framework excluding sources with high

media content. Based upon the literature review, a subjective method is used to gain an

insight in the relevance of portable alpha being in sync with the aim. Furthermore,

respondents have been informed about the purpose and contents of the research prior to

conducting the interviews.

2.9.2. External ValidityAs aforesaid, generalization in the form of replicating research findings to larger sample

and universes remains daunting for the research. Although as Yin (2003:37) argues the

attempt of the research of a qualitative nature is not so much on statistical generalizationbut more on analytical generalization and thus providing insights. However the

triangulation of interviewee sources, in combination with a literature review grounded

in a deeper context beyond our specific context and the usage of reliable objective

interviewees enhances the ability to generalise.


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Part II

Literature review

Part II encompasses the literature review which is formed as a narrative in descending

order of abstraction. Firstly, chapter 3 clarifies the cornerstones of modern finance and

investment. Subsequently, Chapter 4 analyzes the domain of alpha investing. Lastly,

chapter 5 elaborates on portable alpha.


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3. THE UNDERLYING CREEDThe literature review commences with a minor digression on the academic school of

thought on finance and investments. This body of scholarly research on finance and

investments is of extraordinarily importance as it infuses all financial theory, analysis

and lays the foundation for how participants in the world of finance and investments act

and think. The invaluable grand theories are thus of paramount importance for the

proliferation of new concepts in the world of finance and investments, such as portable

alpha (Bernstein 2005).

The aim of this chapter is to provide an analytical framework based upon the grand

theories of Markowitz (1952), Sharpe (1964) and Fama (1970) and linking thesetheories to the key concept of portable alpha; alpha itself. The analytical framework

commences with analyzing finance in the most abstracted sense and by advancing the

relationship between these theories and the applied concept becomes more apparent.

These abstracted concepts are developed upon the trade-off between abstractionism and

realism. For the purpose of analysis assumptions have to be made which are not likely

to hold, especially in the case of Sharpes (1964) Capital Asset Pricing Model (CAPM).

Hence, these theories and their linkage provide an illustrative aim and tend not to

emphasis on the inherent limitations of the models.

3.1.MarkowitzOne of the first great intellects that changed the school of thought on finance was

Markowitz (1952) with his remarkable oeuvre. His work has primarily two focal points

which were novelties at that time and now dominate the finance and investment

universe. First, he demonstrated that return is inextricably linked to the risk one is

willing to bear and that the rational investor will not disregard risk when seeking return.

In such a world, investors maximize their expected utility by balancing return in regard

to their risk tolerance. Secondly, exhibiting the notion that investors will avoid taking

risk for which they are not compensated. Markowitz demonstrated with his Modern

Portfolio Theory (MPT) that individual security risk can be diversifiable by holding a

portfolio of securities implying that one only has to bear the risk to which the entire


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portfolio is subjected. Therefore, investors participating in the capital markets expect

according Markowitz principles that their (relevant) risk that they are taking will be

rewarded with the concomitant return.

3.2.The Capital Asset Pricing ModelSharpe (1964) made Markowitz proposal more tenable with the development of the

Capital Asset Pricing Model (CAPM). The model elaborates on the risk/return notion

defined by Markowitz. Sharpe (1964) demonstrates that through diversification a

portion of the risk inherent to a financial asset can be avoided and therefore the price of

a financial asset is unlikely to be rewarded for avoidable risk. Total risk is subdivided

into the variability of a financial asset due to the stock market as a whole (systematic

risk) and the irrelevant residual risk due to company specific factors (unsystematic

risk). According the CAPM the function of expected return on a financial security

depends wholly on a financial assets relation to systematic risk () as unsystematic risk

is diversifiable. Consequently in the CAPM an efficient portfolio of assets will have a

linear relationship between expected return and portfolio risk implying that an efficient

portfolio with a higher beta () should shift to the right and cause a concomitant shift in

expected return on the other axis(see exhibit 3.2).

Exhibit 3.2 The Capital Asset Pricing Model (Sharpe 1964)

2

R2

R1

1

Portfolio Risk ()

Exp

ected

Return

Rf


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In a formula the linear relationship between expected return and market risk becomes

more apparent. In equation (3.2) the expected return of an efficient portfolio equals he

risk-free rate plus a risk premium given by the systematic risk of the financial asset and

the risk premium of the market (Jensen 1968). This equation implies that the expected

return is totally dependent on the level of systematic risk and thus a higher beta value

results in a higher expected return.

E(r) 1 = rf+ 1 [E(r)m - Rf] E(r)2= rf+ 2 [E(r)m - Rf] (3.2)

E(r) 1 = Expected return portfolio

Rf = the one-period risk free rate

E(r)m = Expected market return

1 /2 = Exposure to beta risk

The CAPM is essentially underpinned by the economic principles of equilibrium: a state

of the world where supply equals demand. In an idealistic financial world, supply and

demand of financial securities settles at equilibrium point were systematic risk is

concomitant with its risk premium. If systematic risk () is the only relevant risk this

implies that market forces will push financial assets in quantum leaps to be in sync with

their risk reward trade-off and investor returns should equalize to the relevant risk and

risk premium.

This rather idealistic perspective on equilibrium is improbable to hold at all times in the

financial markets. As Bernstein clarifies (1999)

Equilibrium is a state of nature that can only exist in the absence ofuncertainty, only in a static rather than a dynamic environment, only when

agents make decisions on the basis of perfect foresight.

These conditions required for financial markets to be in perpetual state of correct

equilibrium, seems implausible in practical reality. Sharpe (1964; p433) already

manifested that to derive at equilibrium, necessary for the development of the CAPM,

assumptions had to be invoked: (1) all investors can lend and borrow on equal terms and

(2) the assumption of homogeneity of investors expectations which are unrealistic

assumptions. However, Sharpe (1964) notes:

The proper test of a theory is not in the realism of assumptions but the

acceptability of its implications.


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In practical reality it is reasonable to assume that this artificial concept of equilibrium

does not hold and that the price of financial assets will not entirely be a function of

market risk and its concomitant systematic risk premium. In such a case, financial assets

or financial markets may lend themselves for situations in which the risk premium is not

in correspondence with their systematic risk profile () resulting in returns that exceed

the normal risk premium, this is the so called alpha ().

Jensen (1968) demonstrates that the direction of the alpha can be either, positive,

negative or neutral. An investor with superb forecasting skills might end up at

generating above average returns, i.e., positive alpha (1). A neutral alpha result is one

of the possibilities this occurs when the random selection effects in the portfolio nullify

each other. A negative alpha occurs when the costs to forecast superior returns are

higher than the factual returns resulting in a negative alpha (2) (see exhibit 3.2).

Exhibit 3.2.1 Graphically display of alpha performance (author)

Jensen (1969) developed a performance metric to measure the alpha component in a

portfolio. In this equation (3.2.1) alpha is the risk-adjusted performance of a portfolio in

respect to CAPM.

p = rp [rfp (rm - rf)] (3.2.1)

Utilizing Jensens equation alpha results may be positive, neutral or negative but also

alpha can be generated either by (Warwick 2000):

R1

Expected

Re

turn

R2

Rf

1

1

2

2


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(1)Investments returns that yield higher returns than their benchmarks for similarrisk

(2)Investments with a similar risk profile yielding excess returns

To quote Bernstein (2005) the CAPM is a theoretical triumph and an empirical disaster

insinuating that the assumptions required to abstract the model and arrive at equilibrium

are far from realistic. In practical reality financial markets deviate from the correct

equilibrium for financial asset prices providing leeway for alpha, although until which

extent holds this deviation from efficient financial markets? The answer to this question

is more likely to be a transitory truth than a universal truth.

3.3.The State of Market EfficiencyPrior to the arrival of Famas (1970) Efficient Market Hypothesis (EMH) the world

view dominated that diligent research was rewarded with higher returns, i.e., markets

were inefficient in properly setting financial asset prices. With the advent of the EMH

the state of market efficiency was challenged and alleged that markets were efficient

until such an extent that all publicly available information was fully incorporated in the

security price (Ambachtsheer 1994). Then again the proliferation of academic evidence

in the last 20 years refutes this stance and financial markets appear to be less efficient

than presumed (Malkiel 2003).

An additional perspective is to argue that markets are efficient and that these markets

adjust themselves to incorporate additional risk factors. In other words, asset prices do

not coincide along the CAPM line but settle in equilibrium at a different level allowing

for bearing higher risk. For instance, the small cap effect leads, in comparison to large

caps to higher profits, i.e., abnormal profits, although this could also be a higher risk

premium for illiquidity reasons (Fama and French 1992).

The consensus about the efficiency of the market appears to be divided, although there

is still a huge body of academic evidence on efficiency or near efficiency. In this

context the argument of Bernstein (2005) seems plausible, arguing that as long as stock

market participants remain human beings, irrational behaviour is likely to persist beingendorsed by a large body of academic evidence (Shiller 2000; Mandelbrot and Hudson


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2004 and Tversky and Kahneman 1974; 1979) Consequently, pricing irregularities and

predictable patterns in the stock markets can appear over time and even persist for

shorter periods of time. Nevertheless, these abnormal profits or statuses of

disequilibrium cant be perpetual and as Miller (2000: p.1) says:

Abnormal profits wherever they are found inevitably carry with them seeds of theirown decay.

In such a world, it is probable that alpha will continue to emerge and submerge in

different occasions and financial markets.

3.4.Conclusion

As has been manifested these grand theories caused an extraordinary leap in human

thinking in the area of finance and investments providing the nexus between the

underlying theories and the conceptualization of alpha. Markowitz (1952) exhibited

that risk and reward are inextricably linked and that not all risk is relevant and therefore

not rewarded. The CAPM makes these propositions more tangible and demonstrated

that one is only rewarded for market risk and thus financial asset prices are a function of

systematic risk in respect to their financial market, given that the financial market is inperfect equilibrium. Fama (1970) analyzed the state of efficiency of the financial

markets and thus the scope for alpha investing. Although, the notion of market

efficiency is more a transitory truth than a universal one, meaning that markets are in

eternal state of convergence and divergence towards perfect equilibrium.

The important point is that prior to the theories of Markowitz and Sharpe analyzing

investment performance would not have been possible. Without their respective theories

measuring and identifying alpha would be difficult if not impossible. Furthermore, the

CAPM has many assumptions to make the model work and arrive at equilibrium, in

cases where this does not apply might demonstrate where alpha can be generated.


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4. ACTIVE MANAGEMENT: THE QUEST FORALPHAThe former literature review on the underlying grand theories demonstrated that these

invoked the conceptualization of alpha. This chapter performs a literature review on the

particularities of alpha investing which are central for the understanding of portable

alpha. The aim is to elucidate the characteristics of alpha investing and its context in

portfolio investment.

4.1.The Domain of Active ManagementTo what extent one beliefs in market efficiency and thus the settlement of financial

assets at the correct equilibrium price influences ones stance and approach to

investment. Investors convinced that markets approach high levels of efficiency, are

inclined to agree with market average returns (equilibrium returns) as in such markets

outperformance is a daunting quest. Investors holding a belief that a particular market

is not highly efficient and thus providing leeway for alpha, will attempt to have above

average market returns.

Investors believing in a strong form of market efficiency, in which obtaining abnormal

profits is only for the rare few, employ passive portfolio management. This passiveapproach takes a financial market, asset class or style benchmark as calibration point

and tracks the selected benchmark in the preferred level. The name of passive investing

might lead to the assumption that passive investing is total passive, however even in a

passive modus trading takes place to rebalance the portfolio as it deviates from the

selected benchmark.

The active manager refuses to accept average returns and tries to beat his asset or style

benchmark. These managers usually trade on perceptions of mis pricings which tend to

change relative frequently and thus require active trading to exploit these pricing

misperceptions, hence the term active management (Sharpe 1991). In the endeavour

to pursue alpha, investors compose a portfolio that will yield above average returns, i.e.,

alpha, in respect to the chosen benchmark.

The key issue in building alpha portfolios is the usage and application information

analysis. Alpha management strategies are based on applying information to achieve


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superior returns by forecasting alpha returns that are not yet impounded in the price and

translate these forecasts in alpha portfolios. Information is therefore crucial for

predicting alpha and the transformation of these alpha forecasts in portfolios (Grinold

and Kahn 1992). In such a case, managers with superior forecasting skills are likely to

build alpha portfolios. However by composing alpha portfolios no manager has enough

skill to yield alpha without undertaking additional risk, i.e., active risk (Waring and

Siegel 2003).

4.2. Market Risk and Active Risk: Unconditional and Conditional RewardsIn the search for alpha, managers deviate from market risk and expose themselves to

active risk. Investments in alpha or beta universe are subject to different risk principles.

This distinction between market and active risk lies at the heart of alpha investing. To

illustrate this, total risk is subdivided according Sharpe (1964) into (1) market risk and

(2) active risk with their distinct implications for investments.

According Sharpes (1964) principles financial markets function in such a way that

investors are solely rewarded for relevant risk, i.e., market risk. Therefore riskier

financial markets provide a higher risk premium than financial markets subject to less

market risk. Thus, an investor holding a diversified market portfolio is expected to be

rewarded with a risk premium according to the markets risk. Additionally, could there

be noted that the principles of arbitrage are likely to force beta risk and return within

their premium profiles. In this beta universe, market risk and the return premium are

inextricable linked and thus market risk is unconditionally rewarded.

In an alpha universe, investors attempt to capitalize on market inefficiencies and deviate

from a market risk diversified portfolio exposing them to idiosyncratic risk, which is

irrelevant risk and thus not rewarded. Therefore this risk is conditionally rewarded and

contingent upon the probability of the alpha manager to yield alpha in the financial

markets. At aggregate level market returns are shared by all market participants and in

the quest for alpha, market participants are betting against each other, consciously or

unconsciously, to buy financial assets at an incorrect equilibrium price. The probability

of generating alpha is a so called zero-game because obtaining alpha goes at the

expensive of other market participants (Waring and Siegel 2003).


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The conclusion here to be drawn is that investing in alpha and beta universes are

conditionally and unconditionally rewarded. Investors deal differently with these two

types of risk and have different risk aversions for market and active risk (Grinold and

Kahn 2000). This different risk aversion stance seems logic as investing in the market is

unconditionally rewarded by the market average return whilst taking active risk does

not per se materialize in generating the foreseen alpha.

The distinction of market and active risk in portfolio context is well explained by

Waring et al (2000) demonstrating that due to these different risk aversions the real

impact of active risk is much higher than one would assume. These authors manifest

that aggregating active risk and market risk under similar risk aversions would result in

portfolio risk that is not much lager than beta risk in isolation, i.e., total risk is

Pythagorean (see exhibit 4.2).

Exhibit 4.2 Alpha and beta risk aggregation (Waring et al 2003)

Although Waring et al (2000) demonstrate that this is improbable to apply in portfolio

context as investors apply different risk aversion to market and active risk. Therefore

the actual felt impact of active risk on the portfolio is significant larger on total

portfolio risk (see exhibit 4.2.1). This discloses the real impact of active risk on total

portfolio risk and explains the prudence of investors in engaging in alpha investing.

Total Risk (Active risk + policy risk)

Active

Risk

Risk of the Policy Benchmark


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Exhibit 4.2.1 The real impact of aggregating alpha and beta risk (Waring et al 2003)

4.3.Alpha Returns: the Alpha UniverseIn the previous chapter, there has been manifested the difference in policy risk and

active risk with their different implications for investment portfolios. The conclusionwas drawn that investors have a different risk aversion towards active risk and therefore

will be more cautious in taking active risk to exploit alpha. This chapter analyses the

scope for generating alpha and the likelihood of active risk being rewarded.

The foremost factor to be present is an inefficient market to provide leeway for alpha

returns. Numerous academics have challenged Famas (1970) EMH that markets are

improbable to attain semi-strong levels of efficiency and that public information

occasionally might lead to alpha. Although academics do not seem to have consent on

the state of market efficiency, although it seems plausible to assume that as long as

financial markets are not completely efficient there is leeway for alpha returns. In

addition, as Waring and Siegel (2003) say as long financial market participants

difference in intelligence and skill level persist, it is likely to assume that financial

markets lend themselves for alpha.

Felt Total risk

Active

Risk

Risk of the Policy Benchmark


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Not all financial markets are comparable in their state of efficiency or inefficiency.

Some markets might attain levels of almost perfect efficiency in such a market the

scope for alpha investing becomes very challenging. Other financial markets might

attain lower levels of efficiency providing other possibilities for generating alpha. This

multitude of financial markets provides an entire scale of alpha extraction possibilities.

As Leibowitz (2005) emphasizes, market inefficiencies might exist this does not make

them immediately suitable for alpha extraction. The argument is made that market

inefficiencies may be unstable and unpredictably have under and overshoots,

exploitation may be impeded by counter forces or technical restrictions or they may

resolve quickly. Hence, even tough market inefficiencies exist; they are not all equitable

to serve the purpose of alpha investing.

Thus, market inefficiencies should be lengthy and sufficiently stable for the alpha

strategy to be worthwhile. These market inefficiencies cant be perpetual otherwise

active risk would be unconditionally rewarded and this would of course be the holy

grale. These patterns of inefficiency change as financial markets transform and shift one

from state of equilibrium to another. In case of imperfectly efficient markets, such an

equilibrium transits from one state of inefficiency to another state of inefficiency. This

dynamic feature reduces the propensity for alpha engines to be consistent and thus

worthwhile to exploit. (Leibowitz 2005).

4.4.The Human (skill) FactorGiven that market inefficiencies exist, in certain instances have a degree of

sustainability and are likely to persist, it seems sensible to undertake active risk for the

pursuit of alpha. Nevertheless market imperfections with a degree of sustainability are

not sufficient, it is the human intellect applied to information analysis and

transformation of such an analysis in a portfolio that determines the ultimate success of

alpha.

As aforesaid, alpha investing is a zero-sum game in which market participants bet

against each other. In aggregate all these market participants in the market will earn the

return on the market, therefore positive alpha by investors needs to be balanced by

negative alpha by others. In such a context, it is reasonable to assume that not all


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investors will beat the market returns or create positive alpha. In equilibrium this zero-

sum game would not be possible, although it is likely to assume that the level of

heterogeneity in market participants intelligence, differences in information and skill

level is likely to persist and add up to alpha returns (Waring and Siegel 2003).

Managers demonstrating consistent above average performance are not numerous,

although the existence of superior active managers is endorsed by the academic

literature Brown and Goetzmann (1995) confirm that as well superior and inferior fund

performance is inclined to persist over consecutive years. Moreover, Chen et al (2000)

and Baker et al (2005) demonstrate that stock picking skills by individual managers

exists and translates into higher performance. Litterman (2003) argues that the

proliferation of mutual funds in the last decade serves as an additional testimony to the

ability of human skills to exploit alpha.

Consequently, the task for an investor wanting to utilize alpha managers is to identify

these superior managers capable of generating alpha. In the short run managers could

generate alpha through skill or simply a degree of luck. Investors are looking for alpha

managers with skill which serves as an indicator for sustainable performance. However,

it is unlikely to assume that skill will lead to perpetual alpha as market inefficiencies

change over time. For investors including active managers in their portfolio, it is of

paramount importance to separate the wheat from the chaff: distinguish between

managers capabilities to yield alpha and through mere luck. Perhaps for investors

lacking the skill of recognizing superior managers it would wise perhaps to not engage

in active investing. For those lacking the skills the probability that active risk will be

rewarded with alpha returns decreases as potential alpha performance cant be predicted

with a degree of certainty.

These investors are seeking for managers that could lead to consistent alpha

performance. Since luck is not under the control of the investor and might evaporate, it

is skill that might lead to persistent alpha performance. Harlow and Brown (2004)

argue that investors can improve their probability of choosing suitable active managers

by recognizing that past performance is more likely than not to repeat.


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4.5.The BenchmarkIn the quest to yield alpha, managers performance is contrasted to a benchmark or a

well diversified portfolio. For simplicity reasons, the CAPM model was used to

decompose risk in a market and active risk component to distinguish between marketreturns and alpha returns. In a real world context, it is unlikely that a single beta-factor

model is complete in explaining market risk and alpha returns might have a different

exposure to market risk than desired. Therefore a multi-factor model such as the

arbitrage pricing model propounded by Ross (1976) is suggested to be more purposeful

in explaining market risk and thus used for developing an adequate benchmark. In a

multi-factor approach, managers returns are explained in terms of beta exposure to

these different factors. However, as Arnott and Bernstein (1990) remark: risk is such a

many headed monster that selecting the right head to focus on can be a major challenge.

Pension funds are improbable to all be subject to exact similar risk factors; therefore

their definitions of relevant risk might differ and set different benchmarks. Without

having benchmarks it would be impossible to quantify alpha performance as there is no

calibration point for comparing the risk and return of the active manager. The

designation of a benchmark to an alpha manager will severely impact the alpha

performance.

After having determined the customized benchmark, the managers task is to beat his

assigned benchmark in the quest for alpha. By beating the benchmark his total

performance consists of a part exposure against his benchmarks and generated alpha.

The valuable contribution of the manager is not his total return but solely the portion of

the return over the benchmark, resulting in the so called pure alpha.

In the quest for generating alpha, managers have a benchmark target and a tolerance set

for deviation of this benchmark, i.e., how many active risk may the manager undertake.

This deviation from the benchmark is the so called tracking error defined by Tobin

(1999) as the percentage difference in total return and index fund and the benchmark

index the fund was designed to replicate. In active management, the tracking error

represents the proportion of active risk undertaken relative to the benchmark.


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4.6.Measuring Investment Performance: The Information RatioThe information ratio (henceforth IR) relates all the aspects of alpha investing discussed

so far. It is the ratio utilized to determine the value addition of an alpha manager and

according Grinold (1989) perhaps the single most important metric for this purpose.The IR represents the amount of alpha per unit of active risk undertaken to achieve this

outperformance, relative measured to a benchmark. In other words, how much alpha is

generated in respect to deviation from a given benchmark (see equation 1).

Information Ratio = / (4.6)

= Pure active return

= Pure active risk [Tracking Error]

In the equation, the IR is dependent upon alpha and the active risk undertaken

represented by the tracking error, to arrive at the value addition of an investment

strategy. The IR makes it possible to compare the added value of investment managers

with a very different risk/return trade-off

A very offensive alpha strategy taking a lot of incremental risk which yields a

concomitant alpha has the same added value as a defensive alpha strategy with less

incremental risk rewarded with concomitant alpha. Hence, as long as the active returns

causes a proportionate change in active risk the value addition of the investment

strategy remains constant and hence employing a more offensive strategy which is met

with a proportionate shift in alpha does not translates in a more valuable active

investing strategy (Waring and Siegel 2003). This has two important implications:

(1)All investors investing according mean-variance objectives will prefer thehighest possible IR

(2)Investors with high risk aversion will be less aggressive in exploiting theinformation and will thus have lower value added strategies

Although what is considered an appropriate relation between active risk and alpha?

Grinold and Kahn (2000) alleged that an IR of .5 is good, .75 is very good and 1.0 is


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exceptional. Levy and Jacobs (1996) argued for similar figures and quantified that a

good manager might have a .5 and an exceptional manager attains 1.0 level.

4.7.Alpha Performance ConstraintsThe information Ratio is based upon the assumption that the pursuit of alpha can be

done without any restrictions. Nevertheless, in the real world investors often face

restrictions that hamper their ability to maximize alpha and thus the materialization of

the forecasted IR. Grinold (1989) emphasis this point and asserts that the IR ratio should

be considered as an upper boundary for analyzing the value addition of an investment

strategy, as issues hampering alpha performance and costs for generating alpha have not

been subtracted.

Investment is confronted with several forms of constraints impeding alpha performance.

Some of these constraints are imposed by governments, regulators, the financial markets

and apply to the collective of investors. Within these frameworks, fiduciaries impose

constraints on their investment managers by narrowing the investors freedom to act and

thus limiting the full scope of available opportunities to generate alpha. Some of these

constraints are totally logic to control excessive risk, although others are self-defeating.

Litterman (2005) demonstrates how certain constraints set by pension fund trustees

interfere with an investment managers alpha strategy whilst remaining within the set

risk limits resulting in a lower IR. It appears logical to curb investment managers

ability to act by rules set at the fund level, although it is very illogic to employ an alpha

manager with a certain style that is impeded by these fund constraints and thus unable to

deliver the expected alpha even staying with the defined risk budget and boundaries.

Therefore, the suggestion goes that pension fund trusts should weigh if their set

investment constraints are in sync with managers skill, of course until the extent that

hes able to deliver the IR identified by the pension fund.

A constraint with a very severe impact according Litterman (2005) on an investment

mandate is the restriction to take place in short-selling resulting in holding a long-only

portfolio. The exclusion of short-selling limits the scope of activity and thus

engagements of alpha strategies that require short-selling. Also Jacobs et al (1999;


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1997) demonstrate the positive effects of abolishing long-only portfolios. This

restriction in portfolio context leads to suboptimal usage of alpha performance.

4.8.The Costs of the Quest for AlphaThus far, the emphasis has been on alpha on paper, i.e., alpha prior to all expenses.

Investors are considered with total wealth creation net of all costs and alpha strategies

are quite cost intensive in comparison to passive strategies. These costs for an alpha

strategy can be broadly defined in two cost posts: (1) costs of generating the

information and (2) costs associated with the investment strategy.

As Grinold (1989) mentions that strategies with a high turnover are more probable to

have a larger proportion of costs since such a strategy requires high transaction costs

and more active trading.

Additionally, active investors are liable to tax obligations increasing the barrier for

alpha investments to be profitable or worthwhile. Especially, alpha strategies

encompassing a high turnover strategy subject to capital gains tax (CGT). Arnott and

Jeffrey (1993) demonstrated in their empirical evidence the impact of turn-over

generated taxes on alpha investing and concluded that most managers alpha are thus

not large enough to cover taxes. However, not all alpha investing strategies are based

on high-turnover and pension funds in the Netherlands are exempted from paying taxes.

In addition, they argued that overlay strategies might counter the tax effect for high-turn

over alpha strategies and this is exactly what a portable alpha strategy is.

4.9.Building Active portfolios: Maximizing Alpha ReturnsIn the latter chapters, the scope of alpha investing for individual portfolios has been

discussed. For large institutional investors alpha decisions are taken at aggregate and are

a matter of constructing a portfolio of active managers. In a portfolio context the aim is

about optimizing total active return against total active risk whilst dealing with misfit

risk between individual managers to maximize expected return for a given level of risk

across all active managers (Waring and Siegel 2003; Waring et al 2000).


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At aggregate level the active portfolio has the following expected utility (see equation

4.9). Simply stated, the expected usefulness of the alpha portfolio equals expected alpha

of the alpha managers combined minus the combined active risk. This active risk in

portfolio context includes active risk of the individual and the misfit risk across the

portfolio.

E(U) = E(p) - . E(2A) (4.9)

E(U) = the expected utility of the active management component in the portfolio;

E(p) = expected alpha on the portfolio;

= the degree of risk aversion;

E(2A) = the active risk of the portfolio aggregating individual manager risk and net

misfit risk across the portfolio

This equation can be used to draw an efficient frontier for the investors desired level of

risk aversion for active risk (see exhibit 4.9). In balancing active risk and return across

the portfolio, expected alpha performs a key function in portfolio optimization as active

risk is optimized against expected alphas. Furthermore expected correlation between

managers alphas are required and of course their exposure to the market factor that

describes the normal portfolio.

Exhibit 4.9 - Efficient Frontier of Alpha Managers (Waring et al 2003)

Active risk

Expectedalpha[E()]

No Risk

Moderate RiskHigher Risk


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4.10. The value Addition of AlphaAlpha investing is a difficult process and conditionally rewarded, although the results of

alpha might justify the effort. Theoretically speaking, pure alpha returns are

uncorrelated with beta returns and thus risk reduction (mean-variance) can be achievedto reduce overall portfolio volatility. It appears to be logic for alpha investing to be

uncorrelated with beta sources as alpha investing is dependent upon market

inefficiencies and human skill to extract these. Although, practical reality has proven

that these alpha strategies do display some form of correlation (Kung and Pohlman

2004).

The other benign factor is obviously alpha returns itself. Which investor is not seeking

for above average market returns? Especially at times of relative low returns on the

capital markets, alpha might provide incremental returns.


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5. PORTABLE ALPHAThis last part of the literature review arrives at the concept portable alpha. The literature

review clarifies the functioning and the aim of the concept. Portable alpha is contrasted

against the conventional investment approach to make the benefits apparent.

Furthermore, the limitations and difficulties inherent to the approach are discussed.

5.1.The ConceptIn the essence, the concept of portable alpha according the definition of Coates and

Baumgartner (2006):

A financial engineering methodology that seeks to add low correlation sourcesof return (alpha) to a portfolio while maintaining the total portfolios desired

systematic (beta) exposures

The core of portable alpha is based on the notion that the quest for alpha is separable

from the portfolios desired beta exposures, i.e., its asset allocation policy. In this

concept the entire alpha universe can be used for finding appropriate alpha sources to be

included to the portfolios beta investments. Conventionally speaking the quest for

alpha sources results in ending up in beta exposure, which can be entirely or partially

unwanted for the portfolio. In other words, investors having located an interesting

market for alpha extraction have to invest in the market to extract alpha and normally

would have to expose themselves to markets which are out of sync with their asset

allocation policy.

Therefore in a portable alpha universe, financial derivatives are employed to liberate

alpha from their underlying asset classes. These derivatives are used as a synthetic

overlay on the portfolio neutralizing the beta and resulting in residual alpha of the

manager. These alpha returns are thus separated from their beta source and are ported

back to the portfolio of investments without having to change the underlying asset

allocation of the portfolio resulting in a portfolio optimized for the desired alpha and

beta exposures (See exhibit 5.1).


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Exhibit 5.1- The portable alpha concept (Gerritsen 2006)

5.2.The Portable Alpha Approach versus the Traditional ApproachThe benefits of a portable alpha approach in isolation are perhaps not that evident.

These might become more apparent by comparing the traditional investment approach

and the portable alpha approach. Therefore both approaches are contrasted to

demonstrate the effects of portable alpha in a pension fund investment context.

The traditional investment approach follows a top-down investment structure; thus

starting at macro-level narrowing down the scope. In this approach, the first decision is

the asset allocation decision determining how the total investment portfolio shall be

subdivided in asset categories and weightings. In exhibit 5.2 the process of a

conventional portfolio is explained and illustrated with fictive numbers. To put this

decision fist appears logic as Brinson et al (1986; 1991) demonstrated that the choice of

asset classes and weightings of these asset classes have the largest impact upon

investment performance. Consequently, the stance on deviation from the asset

allocation is set. Does the fund allow for strategic deviations from the intended policy or

is the portfolio allowed to drift with the whims of the financial markets? Ultimately, the

decision is made whether to employ alpha or beta management of a portfolio, i.e., active

versus passive management.

Arnott (2002) remarks that thus in such a traditional approach, the strategic asset

allocation dictates the investment process. Hereby the asset allocation decision is

inextricably allied to investment decisions further down the line and the quest for alphahas to be pursued within the asset classes and their proportions. In the simplified exhibit

Neutralizing theundesired by

means of

derivatives

Portable alpha

Undesiredmarket

exposure

Alpha source

Portable eta

Total portfolio


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5.2 the quest for alpha is limited by the three asset classes (bonds, equity and

international equity) and their respective weightings. To put the asset allocation

decision first and abiding by it in the strictest sense has the following implications for

alpha in portfolio context:

Exhibit 5.2 Conventional portfolio approach (Author)

First, alpha has to be generated within the asset classes and these proportions.

Therefore, the information ratio cant be optimized because alpha within these market

are given and increasing the risk budget does not trigger a disproportionate alpha

resulting in a higher IR. Furthermore, risk budgets are set in accordance with the

proportions the asset have and induce a concomitant alpha. Hence, the result of alpha

performance is the weighted average of the asset classes multiplied by the suboptimal

IR (see equation 5.2).

E(r) = (WBonds IRBonds ) + (WEquity IREquity ) + (WInt.Equity IRInt.Equity)

(5.2)E(r) = Expected Return on the Alpha portfolio

W = Weighting of the asset class

IR = Information Ratio

Secondly, this automatically excludes managers with IR that do not fit within the asset

allocation decision. Thirdly is the inability for reducing total alpha risk in the portfolio.

Then again alpha strategies have to take place within the asset allocation mix; therefore

selecting managers that have non-correlated alpha styles is limited. Hence, the

Asset Allocation

decision ()

The scope for

alpha

IREquity= equity / Equity

Bonds (.5) Equity (.4) Int. equity (.1)

Investment portfolio

IRBonds= bonds / Bonds IRInt.Equity = int.Equity

/Int.Equity

Suboptimal correlation ()Alpha risk

reduction effect


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possibility for optimizing an alpha portfolio is limited because IR returns and the risk

reduction effect are determined by the asset allocation mix, this effect becomes apparent

in equation (5.2.1).

= (WBonds IRBonds) + (WEquity IREquity) + (WInt.Equity IRInt.Equity) + suboptimal (5.2.1)

= alpha portfolio risk, expressed in terms of volatility

suboptimal = Suboptimal correlation

In contrast to the conventional approach, the portable alpha approach frees the

investment policy from the Janus faced nature. At aggregate level the investments are

subdivided in a beta and alpha portfolio (see exhibit 5.2.1). The alpha portfolio is given

a risk budget and the entire continuum of alpha sources can be used to compose an

optimized portfolio. The selection of alpha sources outside of the asset allocation mix

might conduct the fund to unwanted beta exposure inherent to these alpha sources

(Arnott 2002). The application of an overlay, using derivatives neutralizes the

undesired beta and arrives at the desired total asset allocation; this has been

demonstrated in exhibit 5.1. Hereby, the investment portfolio ends up with alpha and

beta decisions which can be optimized in isolation (exhibit 5.2.1)

Exhibit 5.2.1 portable alpha approach (author)

Investment portfolio

portfolio

IRoptimized= highest prospect / risk

IRoptimized= highest prospect / risk

IRoptimized= highest p

Documents

Dissertation - Tom Oor - Portable Alpha, Quo Vadis