Understanding whether returns are derived from alpha or beta is central to portfolio construction. Returns from beta are easily available at very low cost, but returns from alpha are much harder to obtain and, if delivered persistently, result in significant management fees. Larry Siegel is Director of Research for the Ford Foundation where he is part of a team managing a $13 billion fund. We have written previously about Larry’s research into the distinction between alpha and beta, performed in collaboration with Barton Waring and Matt Scanlan of Barclays Global Investors, scheduled to appear in a forthcoming article by the three authors. Drawing on a draft of their article, we look more closely at the subtle and complex issues facing advisors as they select from the realm of asset classes with vastly different performance characteristics.

You can separate alpha from beta

In theory, the return on any asset, no matter how exotic or hard to evaluate, consists of a part that is correlated to some market or set of common factors (beta) and a part that is uncorrelated (alpha). With a suitable benchmark, a statistical regression will determine these parameters for most publicly traded liquid assets. However, for illiquid assets (private equity, venture capital, real estate, and most hedge funds) this calculation is much more difficult, due to the lack of fund transparency and an appropriate benchmark.

In asset classes where index funds are available, alpha and beta quite can be measured accurately and invested in separately. In theory, index funds could be used to obtain the desired beta exposure, and specialized investment vehicles (e.g., market-neutral hedge funds) could be employed to add (or subtract!) alpha. Siegel, Waring, and Scanlan note that this structure has come to be known as “portable alpha” although, he says it would be better named “portable beta” since close to 100% of available capital is invested in the alpha sources and index contracts, which require almost no capital, are used to salt and pepper the portfolio to taste with beta exposures.

Siegel and his co-authors advocate against such extreme structures. Some traditional long-only active managers, who blend alpha and beta, have the kind of exceptional skill required for successfully implementing an active strategy, and those who do should be part of an investor’s portfolio. The authors note that “skill can be found in many places and the investor should take advantage of it wherever he or she finds it,” adding, “But at the same time, the investor should be cognizant of the aggregate of all the beta positions across their asset allocation, and make sure this aggregate is consistent with the intended strategic asset allocation policy.”

Alpha and beta for illiquid alternative investments

Many of the most interesting investments are in alternative asset classes where it is difficult and occasionally impossible to accurately distinguish alpha from beta. These include private equity, real estate, some hedge funds, and partnerships that invest in energy, other natural resources, infrastructure, agriculture, and timber. As Siegel notes, “it is more productive to analyze these exceptions than to keep repeating the mantra that alpha and beta are separable.”

Investment in an illiquid alternative asset resembles a stake in a private company, moreso than it does an investment in a public equity. Investors must confront the lack of a continually updated market price, tolerate the accounting provided by the alternative investment manager, and wait ten or more years to get a full payout of cash and/or marketable securities. At that point it is possible to look back and calculate the performance, but not the correlations with asset class benchmarks that would make it possible to calculate alphas and betas.

Display article as PDF for printing.

Would you like to send this article to a friend?