Implications for Advisors

Distinguishing alpha from beta matters because fees for beta from well-established asset classes should be very low, while fees for alpha are very high. Furthermore, you should select alpha providers carefully so the fees are worth it! Separating alpha from beta (in a clearly defined measurement or evaluative sense, not necessarily by investing separately in them) insures you will pay high fees only for positive expected alpha, not for the delivery of a beta along with random, unskillful alpha production.

Siegel, Waring, and Scanlan note that “a world in which alpha and beta are fully separated and in which investors pay active fees only for alpha is a fantasy.” But the fantasy is at least theoretically available right now, by investing in index (pure beta) funds and market-neutral long-short (pure alpha) funds. Investors would then be literally paying active management fees only for true alpha along with radically lower index fund fee levels for beta exposure. Almost no institutional investor behaves this way, and for good reason. Why not?

First, there’s nothing wrong – even in principle – with buying beta packaged with alpha, as long as the investor believes the manager is skillful and the fees charged are an appropriate blend of the high alpha fees and low beta fees.

Second, to avoid buying beta bundled with alpha, you would have to completely avoid asset classes where the lines are blurred. These include private equity and debt, real estate, and many other alternative investments. At any given time, there are attractive opportunities in one or more of these asset classes, which should not be overlooked just because the benchmarks and index funds that would make it possible to separate alpha from beta in these investments do not exist.

Third, you would be ignoring portfolio designs that mix alpha and beta exposures. These include:

• Traditional long-only active managers

• Hedge funds or hedge-like funds that take some ordinary beta (stock market or bond market) exposure

• Hedge funds or hedge-like funds that expose you to nontraditional forms of beta (e.g., beta that is tied to alternative asset classes)

There is potential value—potential alpha—in all of these blended vehicles. Investors should not ignore these sources of alpha just because they will inevitably wind up paying some alpha fees for beta exposure.

A realistic strategy for implementing a full understanding of the difference between alpha bets and beta bets is:

• In most asset classes—in public markets with transparent benchmarks and liquid index funds and/or ETFs based on those benchmarks—separate alpha and beta as cleanly as possible. To accomplish this,

  • Use more index funds, enhanced index funds, and market-neutral long-short funds
  • Use less traditional long-only active management, focusing on managers identified by the investor as having the skill necessary to deliver truly superior results after fees

• Nontraditional beta exposures, involving assembly charges to make the betas available to the investing public, may be worth a fee substantially higher than a traditional index fee. Try your best to negotiate such a fee in these asset classes.

• Finally, in some asset classes and types of funds, alpha and beta simply cannot be disentangled, and an alpha fee – beyond what can be justified by assembly costs – is charged on the entire return. Knowing that you will pay an alpha fee for the part of performance that is due to beta, invest in these only if the after-fee return you expect is more than sufficient to compensate for all of the risks taken and fees paid.

Such a structure moves the investor a long way toward the ideal of paying alpha fees only for true alpha, and index fund fees for beta. The ideal is not fully achieved but you are much closer than in current practice. Siegel, Waring, and Scanlan hope and expect to see investors adopting this structure in the future. Some of the current trends are in this direction, and the authors are tremendously encouraged by them, but they also see investors paying very high fees for certain alpha sources. Investors will benefit from controlling fees and other investment costs while following the principles of alpha-beta separation as best as one can in a complex world.

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