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Understanding the Sources of Alpha

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Understanding the Sources of Alpha Understanding the Sources of Alpha Robert C. Merton School of Management Distinguished Professor of Finance, Massachusetts Institute of Technology Resident Scientist, Dimensional Holdings Inc. Copyright © 2016 by Robert C. Merton Agenda Two-stage approach to Creating OCRA the investment • Market cap-weighted portfolio: foundation management process: component of the optimal combination of risky assets (OCRA) • Create the maximum Sharpe-ratio risky • Failure of the CAPM implies market portfolio is portfolio, Optimal not OCRA and therefore alpha exists relative to Combination of the passive market portfolio benchmark Risky Assets (OCRA) • Sources of alpha: seeking to create superior • Apply dynamic trading performance over the market portfolio strategies between OCRA • Traditional alpha vs. financial-services alpha: and the risk-free asset performance and sustainability and/or use derivatives to optimize the portfolio for • Traditional alpha vs. dimensional alpha: its specific goal performance and sustainability • The search for dimensional alpha • Hedge funds: a case study exploring alpha- source performance attribution • Applying the three sources of alpha to improve asset management • Global Diversification Pays: A “Free” Alpha Domain of Investment Management Stages of production process for a specified investment goal Passive Benchmark Market Portfolio Efficient Super Efficient Diversification Max Sharpe Ratio Portfolio of Active Asset-Class Risky Assets Allocation Optimal Combine with Alter Shape Structured Macro Sector Mean- State-Variable of Returns on Efficient Form (Optimal Market Timing Variance Hedging Underlying of Returns to Combination of Non-CAPM Equilibrium Portfolio Portfolios Optimal Portfolio the Portfolio Risky Assets) to Fit Goal Riskless Superior Performing Asset Micro Aggregate Tailor payoffs to Portfolio Excess-Return specific goal Portfolio • Dynamic portfolio • Expropriation “Alpha Engines” strategies and efficient derivatives to create • Regulatory efficient nonlinear payoffs • Liquidity tradeoff • Components of • Risk modulation through • Risk modulation with max Sharpe-ratio hedging or leveraging insurance or non-linear • Transaction risky assets-only risky portfolio leverage cost efficient portfolio • Constrained • Pre-programmed • Diversification asset holdings dynamic trading risk modulation • OCRA market timing • “Building block” state- active management contingent securities to create specialized payout patterns For illustrative purposes only. Constructing the Optimal Combination of Risky Assets (OCRA) Passive Benchmark Market Portfolio Efficient Super Efficient Start with the market cap-weighted passive index for Diversification Max Sharpe maximum diversification. Ratio Portfolio of Active Asset-Class Risky Assets If CAPM does not hold, then it is possible to increase the Allocation Sharpe ratio over the passive benchmark; thus “alphas” Macro Sector Market Timing from active management exist but they must be identified. Non-CAPM Equilibrium Three different sources of alpha: Superior Performing • Market information inefficiency: traditional alpha Micro Aggregate Excess-Return Portfolio • Market frictions and institutional rigidities: “Alpha Engines” financial-services alpha • Other systematic risks in addition to market-portfolio beta: dimensional alpha The passive and active components are combined to create OCRA. Failure of CAPM Implies Alpha Exists for Market Portfolio Benchmark Stages of production process for a specified investment goal Possible reasons for CAPM failure: • Empirical Deviations from – Short-sale restrictions • Uncertainty about relative • Intertemporal Capital Asset CAPM Black, Jensen and and cost prices of consumption Pricing Model Scholes (1972); Fama and – Stock loan limitation goods; (Merton 1973,1975) MacBeth (1973); and tracking Fama/French (1992) • Uncertainty about liquidity • Arbitrage-Pricing Theory requirements Asset Pricing Model • Uncertainty about mortality (Ross 1976) • Market Information • Other Dimensions of Risk and longevity Inefficiency: Traditional besides Market Beta Alpha • Consumption-based Capital • More-Complete Equilibrium • Hedging roles for securities Asset Pricing Model Asset Pricing Models: • Market Frictions: Affected by in addition to diversification (Breeden 1979) Technology, Institutions, Multiple Betas and Risk and Regulation • Uncertainty about the future Dimensions with Risk • Fama/French 3- or 4-Factor Premiums Model (reduced-form model) – Institutional rigidities investment opportunity set; from regulation or i.e., changing interest rates, charter/prospectus volatility and Sharpe ratio restrictions/requirements risks – Taxes and accounting • Uncertainty about human • Where βjk is the rules capital labor income (theoretical) multiple- – Leverage inefficiency; regression coefficient from • Uncertainty about inflation borrowing constraints regressing the return on and the menu of possible security j on the returns on consumption goods in the the “m” dimension portfolios, future “E1,...,Em” Market Cap-Weighted Index Portfolio is Always an Important Component of the Optimal Combination of Risky Assets Total Portfolio Risk-Return Portfolio Component Risk-Return Passive Benchmark Market Portfolio Efficient Diversification = + S = Sharpe Ratio Domain of Investment Management Asset-Class Allocation example: Macro-Sector Market Timing “Long-Short” combinations to change fractional allocations from Benchmark Weights Asset Class Benchmark Weight Long (Short) Incremental Revised Weight Small Cap Equity 5% +5% 10% Mid Cap Equity 10% 0% 10% Large Cap Equity 30% (10%) 20% Emerging Market Equity 15% (5%) 10% Domestic Fixed-Income 30% 5% 35% Real Estate 10% 5% 15% 100% 0% 100% Micro “Excess Return” Portfolio: Security Selection: “Alpha Engines” Engine #1 Engine #2 Engine #3 Engine #4 Engine #5 Engine #N US Risk Technical Fundamental Foreign Private Equity Mortgage-Back Arbitrage Analysis of Analysis of Currency Fund Security Relative Hedge Fund Equities Fund Equities Fund Forecast Fund Value Fund Goal: Super-Performing Micro Aggregate Excess-Return Portfolio For illustrative purposes only. There is no guarantee strategies will be successful. Seeking Superior and Sustainable Investment Performance Traditional alpha vs. financial-services alpha Financial-services alpha: financial Traditional alpha: market intermediation of institutional rigidities informational inefficiency and market frictions • Depends on being faster, investors spend 0.67% • Depends critically on being standing, long-horizon, smarter, better models or of the aggregate value lightly regulated, flexible liquidity needs, better information inputs of the market each year with highly skilled large pool of assets, searching for superior professionals who can reputational capital, • Is it sustainable? returns. Society's identify which rigidities are and sponsorship value. Is it scalable? capitalized cost of price binding; diagnose which discovery is at least 10% security prices are • Is it sustainable? 1 • Kenneth French , “The of the current market cap. impacted by the rigidities; Is it scalable? Cost of Active Investing,” Under reasonable devise an efficient trading Journal of Finance assumptions, the typical strategy to provide “the • Hedge funds with light (August 2008) compares investor would increase other side” of the trade to regulation have a the fees, expenses, and his average annual return alleviate the impact of the comparative advantage vs. trading costs society pays by 67 basis points over rigidity on affected regulated institutions in to invest in the US stock the 1980 to 2006 period if institutions; and earn an intermediating institutional market with an estimate he switched to a passive intermediation fee in the rigidities, which defines of what would be paid if market portfolio. form of the excess return their functional purpose in everyone invested on the strategy. Other the financial “ecosystem.” passively. Averaging over • Non-economic costs helpful but not essential 1980 to 2006, finds that and benefits advantages: strong credit- 1. Ken French is a member of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP. Seeking Superior and Sustainable Investment Performance Traditional alpha vs. dimensional alpha • In the CAPM equilibrium, the market portfolio is the • While theoretical structural models suggest the OCRA for mean-variance investors, and those potential identity of these other dimensions of risk, investors hold the same risky portfolio of assets. the search for these dimensions with alphas has However, in more complete equilibrium models, been largely empirical, resulting in reduced-form investors use securities to hedge other dimensions models with surrogate dimensions and factors, of risk in addition to the overall market risk. So in rather than the actual structural ones. Well-known general, investors will not hold the same proportions examples of factors that appear to have significant of risky assets, and thus the market portfolio will not alphas over long time periods and across be mean-variance efficient [aka OCRA], and the geopolitical borders are size of company [small – CAPM will fail. large], ratio of book-to-market value [high – low], ratio of profits-to-market value, and possibly liquidity • The existence of alphas relative to the passive [low – high]. market benchmark is entirely consistent with perfect- market and efficient-market conditions, and these • Alphas from identified dimensions of risk with
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