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So you thought ‘alpha’ was a Greek letter!

16 May 2008 Gareth Stokes

As a newcomer to the world of portfolio and investment management you’d probably think ‘alpha’ and ‘beta’ were nothing more than Greek letters. As a mathematician or scientist you might even have recognised them as the symbols frequently used as coefficie

Beta is a given – alpha separates those that can from the rest

Beta is the return associated with the underlying benchmark. Thus if a portfolio is benchmarked against the JSE Top 40 Index the investor expects that index’s return as an absolute minimum. Of course, the investor is subject to the market movement of the benchmark and is not guaranteed a positive return... Nerina Visser, research analyst with Nedcor Securities observed that the choice of benchmark was often the first ‘active’ decision taken by the fund manager.

Obviously investors want more from their asset manager than a benchmark return. If beta was all that was on offer they’d be better off buying an exchange traded fund to track their preferred benchmark. That’s where alpha enters the mix. Alpha is that portion of return in excess to the return generated by the benchmark. She was one of many who warned that the choice of benchmark could influence alpha – and that alpha was often achieved inadvertently through this choice.

A very basic way to view alpha (and alpha generation) is as fund manager skill. Alpha is in excess to and uncorrelated with market returns. Apart from fund manager skill Alpha can be secured through clever ‘quants’. Daniel Polakow from Peregrine Securities said that alpha was rare and that two thirds of local fund managers (after costs) would have been beaten by an investment in an ETF. He further opined that South Africa was a great place to hide if you didn’t have the required skills to make it in the active fund management environment. He noted the large number of managers who simply tracked indexes while claiming to be active managers. It’s important for active fund managers to concentrate on portfolio construction. Lynn van Coller of RMB Asset Management noted that “more alpha is wasted – a great deal of it inadvertently – through poor portfolio construction than can be replaced from new sources.”

Stumbling blocks to delivering alpha

What do we know so far? We know that beta is a given, provided by the benchmark return. And we know that alpha is the ‘holy grail’ of asset management. What we don’t yet know is why it’s so difficult to secure alpha.

James Barber of SEI noted that market concentration remains the biggest drag to producing alpha in the South African market. This concentration aspect can be demonstrated through a closer look at the companies making up the JSE All Share Index. Barber said the top 20 shares account for 54% of the total index… Shares 21 to 50 account for another 18%, with those in position 51 to 100 making up 11%. So the remaining 600 (or so) listed companies comprise only 21% of the total market. Using the example of an average ‘All Share’ equity portfolio Barber said the fund manager’s optimum strategy would include 56.3% invested in the top 20 component. But going 1% overweight the top 20 would require 76.3% of the portfolio to be made up of just 20 shares – and likewise going 1% underweight would mean shrinking the top 20 holding to just 36.3% of the portfolio. This problem is compounded by the close correlation between South Africa’s largest companies.

Other problems in delivering alpha include market volatility, which has a significant impact. The constraint imposed by long-only fund mandates was also repeatedly mentioned. Active managers feel the ability to use leverage and take short positions in the market are useful tools to secure alpha.

Editors’ thoughts:
Our first impression of the above seminar was that we were in way over our heads. A panel chock-full of academics and industry professionals is always a trifle intimidating. But after a few minutes of intense concentration and a reluctant decision to ignore anything that didn’t make ‘sense’ we actually enjoyed the discussions. Do you deal with alpha and beta in your job – or do you leave it to the professionals? Add your comments below, or send them to gareth@fanews.co.za

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