What Is The Beta Of The Overall U.S. Stock Market Asset Allocation Based On Beta and Alpha Drivers

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Asset Allocation Based On Beta and Alpha Drivers

Asset allocation is one of portfolio management’s primary concerns. Asset allocation answers several questions. What risk-return trade-off are we comfortable with? In other words what amount of risk are we prepared to take to make a certain level of active return? At every level of active return there is an equivalent amount of risk. Many portfolio managers are judged merely on the return they have achieved without subsequent analysis of the risk they took to produce that return. This is the reason why we have seen the advent of new rogue traders like Kweku Odoboli. These traders want to make positions that give a certain amount of return so as to meet their stringent benchmarks.

Asset allocation can be done using either alpha or beta drivers. The alpha drivers measure the manager’s skill to generate the so-called active return. Active return is the difference between the benchmark and the actual return. Alpha is more aggressive and aims to achieve returns in excess of the stated benchmarks. Alpha drivers are normally classified as Tactical Asset Allocation (TAA). TAA facilitates an investor’s long-term funding goals by seeking extra return. It focuses of arbitrage in the sense that it takes advantage of unbalanced market fundamentals. TAA requires more frequent trading than does Strategic Asset Allocation (SAA) to produce the extra returns.

Beta drivers are the more traditional investment techniques that aim to meet the benchmarks. It involves the systematic capture of existing risk premiums. Beta drivers are used in constructing SAA. This type of allocation crystallizes an institutional investor’s investment policy. This process singles out strategic benchmarks tied to broad asset classes that establish the policy/ beta/ market risk. This type of allocation is not designed to beat the market and must meet the long-term funding goals of the organizations like defined benefit pension schemes.

Broad Classes of Alpha Drivers

1. Long or short investing

2. Absolute return strategies (hedge funds)

3. Market segmentation

4. Concentrated portfolios

5. Non-linear return processes (option-like payoff)

6. Alternative cheap beta (anything outside the normal stock/bond portfolio)

Typical Asset Allocation for an Institutional Portfolio

Equity 40%

Fixed Income 30%

Real Estate 15%

Inflation Protection 15%

Breaking down the equity portion

Strategic allocation to equity could be broken down into the following sub-classes:

Beta drivers – 60%

• Passive equity

• 130-30

• Enhanced index equity

Alpha drivers – 40%

• Private equity

• Distressed debt

Convertible bonds have a hybrid structure which is a mixture of equity and fixed income securities thus may be included in either the equity or fixed income bucket.

Fixed income portfolio

This section of the portfolio may also be broken down into alpha and beta drivers. The fixed income portfolio may be allocated in the following way:

Beta drivers – 60%

• US treasury bonds

• Investment grade corporate bonds

• Agency mortgage-backed securities

Alpha drivers – 40%

• Convertible bonds, high yield bonds and mezzanine debt

• Collaterised debt obligation (CDO) and collaterised loan obligation (CLO)

• Fixed income-based hedge fund strategies, fixed income arbitrage relative value, distressed debt

15% Inflation hedging

This is an investment strategy that aims to provide a cushion against the risk of a currency decreasing in value. Other investment may produce returns in excess of inflation but inflation hedging is specifically tailored to preserve value of a currency. The following is how you can split the inflation hedging portion of your portfolio:

TIPS (Treasury inflation protected securities) 20%

Infrastructure 20%

Commodities 20%

Natural resources 20%

Stocks geared to inflation 20%

15% Real Asset Allocation

Real estate is an investment form with limited liquidity compared to other investments, it is also capital-intensive (although capital may be gained through mortgage leverage) and highly depends on cash flow. Because of these realities it is important that this section of the portfolio does not make up the bulk of the portfolio. You could structure your real estate portfolio in the following way:

Real estate investment trust (REITs) 40%

Direct investments 30%

Private equity real estate 15%

Specialized 15%

It is however very important to note that option-like securities are very risky and should be used with extreme caution. This is what brought down the oldest merchant bank in the UK and is what is described by Warren Buffet as “financial weapons of mass destruction”. Portfolio management should be done as conservatively as possible. This means that the bulk of the portfolio should be strategic and the minority should be tactical. It is also very wise to have ceilings on alpha seeking positions that an institution can pursue and have a waterproof internal control system to curb rogue trading.

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