Portable Alpha : a viable strategy for 2019?
2018 Overview and 2019 Outlook
2018 has been the worst year for financial markets since 2008. The vast majority of indices have plunged into a Bear market last year with dips of over 20% from their previous peaks.
The New Year will witness deflating Central Bank balance sheets as expansive monetary policies are tapered out. In fact, the sum of the combined balance sheets of the main Central Banks (Fed, ECB, BoE and BoJ) will diminish for the first time. Whilst liquidity reduction figures are already known, the same cannot be said about the effect they may have on the global economy and on financial markets. The new policies will no doubt call for adjustments to the ways in which assets are managed.
In such an uncertain environment, portfolio construction rules must be reassessed and new investment strategies adapted to the new global context. Expected yields from traditional directional management approaches must be revised downward as we deal with increasing risks. Since a number of industry experts have compared 2018 with 2007, the year 2019 may well be like 2008!
Passive and active managements
There are two kinds of directional or “long only” approaches to managing financial assets. Passive management is the replication of the performance of an index (or “benchmark”) through the use of ETFs (or trackers) as opposed to Active management’s whose primary goal is to beat the benchmark.
Nevertheless, only a few actively-managed investment funds have been able to consistently beat their benchmark over the long run.
Alpha and Beta
The risk (and indirectly the performance) of a fund or an actively-managed directional portfolio can be broken down into two: market risk (Beta) on the one hand and specific risk tied to the fund manager’s selective choices aiming at outperforming the benchmark, on the other.
Beta is a measure of a financial asset’s systematic risk: a single asset, a portfolio or a fund relative to the market or to a benchmark. Beta allows an asset’s expected yield to be calculated as a function of market returns or benchmark performance. If a fund has a Beta of 0.75 it means that, on average, it replicates 75% of both market ups and downs.
Alpha, is a term used to measure a strategy’s ability to beat the market, hence to outperform it.
Alpha generation and convexity
When analysing an actively-managed directional fund one seeks to identify asset managers who are able to generate Alpha with performance convexity. This is an assessment of a manager’s ability to capture a greater proportion of benchmark ups whilst lessening the exposure to its down phases.
Therefore, a fund with a Beta of 0.75 could well replicate on average 100% of market ups and only 50% of market downs… This type of asset is very desirable as it is able to both outperform the market and to lessen risk exposure.
Market outperformance can mitigate important market corrections without necessarily achieving a positive yield.
Suppression of market risk is possible through hedging, that is shorting the asset’s benchmark to eliminate Beta so as to be only exposed to the manager’s Alpha (positive or negative).
The portable alpha technique comes down to isolating a manager’s ability to outperform the market (its Alpha) from its Beta. It is known as an Absolute Return strategy.
This method does not eliminate risk entirely though the latter is no longer directly dependent on market trends bur rather on the manager’s ability to generate Alpha.
Alpha portable strategies open the door to the Absolute Return investment strategy universe beyond the mere selection of alternative funds, to increasing diversification and to improving the risk-return ratios of portfolios.
Moreover, the combination of Alpha-portable strategies with alternative funds that are scarcely correlated to one another, guarantees the resilience of portfolios having to constantly adapt to a changing environment and to new market constraints.
Nevertheless, in order to achieve this result many steps must be taken during the process of selecting funds and investment strategies such as quantitative and qualitative analysis. The principal difficulty resides in the selection of high quality instruments for the generation of alpha. Hence, through optimisation, the best possible combination of selected funds can be achieved by running an optimisation function. The latter must be done on a regular basis.
Portfolio management is likely to be even more challenging in 2019 than it was in 2018.
Being able to adapt to the present environment while overhauling traditional asset management modes has become a necessity. One has to venture outside of the beaten track and comfort zones, in essence: keep innovating now and again and always think differently…This is the challenge each and every multi-manager is faced with on a daily basis!
Thierry Crovetto / CEO of TC Stratégie Financière SAM, Monaco
TC Stratégie Financière SAM is an asset management company located in Monaco. Closely linked to the academic world, our approach is focused on the research that leads to both asset allocation advices and more convoluted quantitative models. From consultancy mandates to “White label investment products”, our goal is to improve investment performance while decreasing the risk of capital loss.