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Strolling With My Alpha

Alpha? Beta? Have the Greeks invaded Wall Street and no one told me? Nah, not the Greeks, more like the quants.

Alpha? Beta? Have the Greeks invaded Wall Street and no one told me? Nah, not the Greeks, more like the quants.

Alpha and beta refer to portfolio investment returns. Simply, beta is the return received by investing in a benchmark, such as the S&P 100, Lehman Aggregate or the Russell 2000. That leaves alpha, which is the return above the benchmark earned from active management. So for a large-cap fund benchmarked to the S&P 100, the S&P 100 return would be the beta, while any excess gained (or lost) from actively managing the portfolio would be the alpha.

So why is that controversial? Frankly, it isn't. The interesting thing is cost structures of each. With exchange traded funds (ETFs), advanced trading tools and super low commissions, benchmarks become cheaper and easier to achieve.

But, while beta is cheap, alpha is expensive. Alpha for traditional funds is created by buying appreciating stocks or bonds. However, there are other ways to skin this cat. With the increase in sophisticated investment products, there are a greater number of ways to profit from market movements, such as through derivatives, shorting, synthetic securities and other creative trading strategies typically outside of the long-only portfolio manager. This creates a need for alternative asset strategies or managers -- aka hedge funds.

Hedge funds have become alpha-generating factories. However, alpha is expensive. Even with increased competition, hedge funds are getting a 1 percent to 2 percent asset management fee and 10 percent to 20 percent of the appreciation.

So what do we do with these concepts? Easy (well not so easy) -- you invest the majority of money in a benchmark and the balance in alternative assets. This way you are tied to your benchmark and gain upside potential from your hedge fund investments. This is called Portable Alpha.

But how does this impact the investment management business? Well, as Bruce Willis says in "Die Hard" -- "Welcome to the paarrty, pal." This strategy turns portfolio managers into asset allocators. Instead of picking stocks, or companies, they pick inexpensive indices and choose expensive hedge funds. What a gas.

In fact, what probably happens is that the portfolio manager goes away and is replaced with a relationship manager. This is not unlike the retail side, where a wealth manager helps the individual investor with asset allocation strategies and then monitors these strategies to ensure they perform. However, in the alpha/beta case, it will be helping the fiduciary allocate its assets between benchmarks and a series of noncorrelated alternative investment vehicles for upside potential. This is not what most portfolio managers signed up for.

If this idea gains traction, it will mean a distinct change in our ecosystem. This will drive larger beta factories (such as Barclays Global and State Street), fewer traditional money managers and a wild array of alternative investment vehicles. Sound familiar?

Now, I am not saying that this is the end of traditional active investment management, or that hedge funds are the "be all, end all." What I am saying is that if you can really manage beta and alpha separately, it is major industry change, creating both tremendous dislocations and significant opportunities. Automation is hitting the portfolio manager, and the cream is skimmed by hedge funds and their community.

Who ever knew that taking my alpha out for a stroll would cause such commotion? <<<

Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio

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