Asset allocation based on beta and alpha drivers

Asset allocation is one of the main concerns of portfolio management. Asset allocation answers several questions. What risk-reward trade-off are we comfortable with? In other words, how much risk are we willing to take to achieve a given active return? At each level of active return, there is an equal risk. Many portfolio managers are judged solely on the return they have achieved without subsequently analyzing the risk they have taken to achieve that return. Because of this, we’ve seen the emergence of new rogue traders like Kweku Odoboli. These traders want to take positions that will yield a specific rate of return in order to meet their strict benchmarks.

Asset allocation can be done with either alpha or beta drivers. The Alpha Drivers measure the manager’s ability to generate what is known as active return. The active return is the difference between the benchmark and the actual return. Alpha is more aggressive and aims to generate returns in excess of advertised benchmarks. Alpha drivers are typically classified as Tactical Asset Allocation (TAA). TAA facilitates an investor’s long-term funding goals by seeking additional returns. It focuses on arbitrage in the sense that it takes advantage of imbalanced market fundamentals. TAA requires more frequent trading than Strategic Asset Allocation (SAA) to generate the additional returns.

Beta drivers are the more traditional investment techniques that aim to meet benchmarks. It is about the systematic recording of existing risk premiums. Beta drivers are used when building SAA. This type of allocation specifies the investment policy of an institutional investor. This process selects strategic benchmarks tied to broad asset classes that set political/beta/market risk. This type of award is not designed to outperform the market and must match the organizations’ long-term funding goals, such as defined benefit plans.

Broad classes of alpha drivers

1. Long or short investments

2. Absolute return strategies (hedge funds)

3. Market Segmentation

4. Concentrated portfolios

5. Non-Linear Return Processes (Option-Like Payout)

6. Alternative cheap beta (everything outside of the normal stock/bond portfolio)

Typical asset allocation for an institutional portfolio

Equity 40%

Fixed rate 30%

real estate 15%

Inflation Protection 15%

Equity Percentage Breakdown

Strategic equity allocation could be broken down into the following sub-classes:

Beta Drivers – 60%

• Passive Equity

• 130-30

• Improved index capital

Alpha Driver – 40%

• Private Capital

• non-performing debt

Convertible bonds have a hybrid structure which is a mix of equity and fixed income securities and can therefore be included in either the equity or fixed income category.

pension portfolio

This part of the portfolio can also be divided into alpha and beta drivers. The fixed income portfolio can be broken down as follows:

Beta Drivers – 60%

• US government bonds

• Investment grade corporate bonds

• Agency mortgage-backed securities

Alpha Driver – 40%

• Convertible bonds, high yield bonds and mezzanine debt

• Collateralised Debt Obligation (CDO) and Collateralised Loan Obligation (CLO)

• Fixed Income Based Hedge Fund Strategies, Fixed Income Arbitrage Relative Value, Distressed Debt

15% inflation hedge

This is an investment strategy that aims to mitigate the risk of a currency depreciating. Other investments can generate returns in excess of inflation, but inflation hedging is specifically tailored to preserve a currency’s value. Here’s how you can allocate the inflation-hedge portion of your portfolio:

TIPS (Inflation Protected Bonds) 20%

infrastructure 20%

raw materials 20%

Natural Resources 20%

Inflation-linked stocks 20%

15% real asset allocation

Real estate is an investment with limited liquidity compared to other investments, it is also capital intensive (although capital can be raised through mortgage leverage) and relies heavily on cash flow. Because of these realities, it is important that this part of the portfolio does not make up the bulk of the portfolio. This is how you could structure your real estate portfolio:

Real estate funds (REITs) 40%

direct investment 30%

Private equity real estate 15%

Specialized 15%

However, it is very important to note that option-type securities are very risky and should be used with extreme caution. This has brought down the oldest merchant bank in the UK and is what Warren Buffet calls “financial weapons of mass destruction”. Portfolio management should be as conservative as possible. This means that the majority of the portfolio should be strategic and the minority tactical. It is also highly advisable to have caps on alpha search positions that an institution can track and to have a watertight internal control system to curb rogue trading.