Alpha Betas

18Sep06

It is not often that The Economist has a free article online that is right up this blog’s alley. In an article in the September 14th edition, “Alpha betting” discusses the continuing bifurcation in the investment management industry. While the growing ETF market provides investors with more (somewhat) low cost avenues to invest, the alternative investment arena, which provides high cost, presumably high return vehicles is simultaneously booming.

At first sight, this might seem like a typical market, with low-cost commodity producers at one end and high-charging specialists at the other. Buy a Rolls-Royce rather than a Trabant and you can expect a higher standard of luxury and engineering in return for the much greater price. But fund management is not like any other industry; paying more does not necessarily get you a better service.[…]

So why are people paying up? In part, because investors have learned to distinguish between the market return, dubbed beta, and managers’ outperformance, known as alpha. “Why wouldn’t you buy beta and alpha separately?” asks Arno Kitts of Henderson Global Investors, a fund-management firm. “Beta is a commodity and alpha is about skill.”

The article goes on to discuss the form that institutional portfolios are taking as they try to exploit these approaches with a “core and satellite” portfolio process. Using low cost, indexed portfolios as the foundation of a portfolio with additional funds seeking out higher returns in the world of alternative investments. While this approach is an attractive on there are of course challenges as well.

Nevertheless investors will probably keep pursuing alpha, even though the cheaper alternatives of ETFs and tracker funds are available. Craig Baker of Watson Wyatt, says that, although above-market returns may not be available to all, clients who can identify them have a “first mover” advantage. As long as that belief exists, managers can charge high fees.

One challenge not always recognized is that beta, while somewhat intuitive, is not always well understood. This point was driven home to us in a post up over at the (new to us) All About Alpha blog. Their point is that beta is product of two different measures which can meaningfully change what beta really measures for any instrument. Read the whole post (and graphs) to get a fuller take on their interesting argument.

While the alpha-beta argument is interesting, it does eventually come down to alpha. So long as there are hedge fund managers generating alpha, and investors who need those incremental returns, betas will necessarily fall by the wayside. That is not to say that beta isn’t important, but the bottom line for investment managers is, quite naturally, the bottom line.

*We apologize if you are still looking for a reference to the Alpha Beta fraternity made famous by the classic 80’s film, “Revenge of the Nerds.”

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