Portfolio Management, Alpha, and Beta

Question 1

1. What are the two major problems with estimating the beta of a hedge fund using historical return data?

Answer 1

Usingpastdatatomeasurebetacausesestimationrisk(inaccuracy). Anothermajorproblemwith estimating beta using historical data is that the true beta being measured may be changing through time.

Question 2

2. How does “separating alpha and beta” differ from “distinguishing alpha and beta”?

Answer 2

Distinguishing alpha and beta involves measurement and attribution and the process of identifying how much of an asset’s return is generated by alpha and how much is generated by beta. Separating alpha and beta involves portfolio management and refers to attempts to independently manage a portfolio’s alpha and beta toward desired levels.

Question 3

3. Define portable alpha.

Answer 3

Portable alpha is the ability of a particular investment product or strategy to be used in the separation of alpha and beta – the ability to being the alpha into a portfolio while being able to control the portfolio’s aggregate beta to the desired level.

Question 4

4. A manager is using the concept of portable alpha to invest $25 million in utility stocks when the manager’s benchmark is a broad equity index. Why would the manager enter futures contracts with a notional value that differed markedly from $25 million?

Answer 4

Note that the porting of alpha in this case requires hedging against any risks of utility stocks due to factors other than the broad equity market (such as high interest rate sensitivity) as well as bringing the risk exposure of the broad equity index up to a beta of one. In practice the strategy might involve a moderately-sized short futures position in futures contracts designed to offset the interest rate sensitivity of the utility stocks and a moderately-sized long position in a futures contract on a broad equity index to bring the aggregated market beta to one.

Question 5

Note that the porting of alpha in this case requires hedging against any risks of utility stocks due to factors other than the broad equity market (such as high interest rate sensitivity) as well as bringing the risk exposure of the broad equity index up to a beta of one. In practice the strategy might involve a moderately-sized short futures position in futures contracts designed to offset the interest rate sensitivity of the utility stocks and a moderately-sized long position in a futures contract on a broad equity index to bring the aggregated market beta to one.

Answer 5

If the alpha is ported perfectly, the total return to this strategy is the combined return of the major bond index and the performance of the REITs relative to the performance of the REIT index (i.e., its alpha). To the degree that the actively managed REIT portfolio is not perfectly correlated (i.e. if alpha is ported imperfectly) with the REIT benchmark, there will be some tracking error, and therefore the total risk of the portfolio is likely to exceed the total risk of the major bond index.

Question 6

6. In the traditional approach to portfolio allocation, what drives the strategic asset allocation decision of an investor?

Answer 6

The top-level decision is a long-term target allocation decision, known as the strategic asset allocation decision. It is based on the investor’s objectives and the perceived risks and returns of the asset classes.

Question 7

7. How does a strategic asset allocation differ from a tactical asset decision?

Answer 7

The strategic asset allocation decision is the long-term target asset allocation based on investor objectives and long-term expectations of returns and risk. Tactical asset allocation is the process of making transient portfolio decisions to alter the systematic risks of the portfolio through time in an attempt to earn superior risk-adjusted returns.

Question 8

8. How do the drivers of portfolio allocation differ using the new investment model rather than the traditional approach to asset allocation?

Answer 8

A traditional approach to portfolio management is focused on imposing a top-down asset allocation with specified weights to each investment category. The new investment model is focused on managing alpha and beta optimally and separately. Thus investors will tend to seek alpha where it can best be found (prioritizing assets that appear to offer the highest alpha) and manage risk separately with the most efficient products available.

Question 9

9. What is the major difference between an actively managed portfolio and a passively managed portfolio?

Answer 9

A passively managed portfolio does not engage in active trading that attempts to generate improved return performance, whereas an actively managed portfolio involves trading with the intent of generating improved return performance.

Question 10

10. List the conditions that are sufficient for a market to be a zero-sum game.

Answer 10

• Investors have the same investment horizon.
• Investors have the same level of risk tolerance.
• Investors are allowed the same access to all asset classes (there is no market segmentation).
• Investors have the same expectations about return and asset class risk premiums.
• Investors pay the same tax rate, or equivalently, there is no tax.
• Investments can be divided and traded without cost.