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-return tradeoff are we comfortable with? In other words, how much risk are we willing to take to achieve a certain level of active return? At each level of active return there is an equivalent amount of risk. Many portfolio managers are judged simply by the return they have achieved without further analysis of the risk they took to produce that return. This is the reason why we have seen the arrival of new rogue merchants like Kweku Odoboli. These traders want to take positions that provide a certain amount of return to meet their strict benchmarks.

Asset allocation can be done using alpha or beta drivers. Alpha drivers measure the manager’s ability to generate the so-called active return. Active return is the difference between the benchmark index and the actual return. Alpha is more aggressive and aims to achieve returns above established benchmarks. Alpha drivers are typically classified as Tactical Asset Allocation (TAA). TAA facilitates an investor’s long-term funding objectives when seeking additional return. It is arbitrage-focused in the sense that it takes advantage of imbalanced market fundamentals. TAA requires more frequent trading than Strategic Asset Allocation (SAA) to produce additional returns.

Beta drivers are the more traditional investment techniques that aim to meet benchmarks. It involves the systematic capture of existing risk premiums. Beta drivers are used in the SAA build. This type of allocation crystallizes the investment policy of an institutional investor. This process highlights strategic benchmarks tied to broad asset classes that set policy/beta/market risk. This type of allocation is not designed to beat the market and must meet the long-term funding objectives of organizations, such as defined benefit pension plans.

Extensive classes of Alpha controllers
1. Invest long or short
2. Absolute return strategies (hedge funds)
3. Market segmentation
4. Concentrated portfolios
5. Non-linear return processes (payment similar to an option)
6. Alternative cheap beta (anything outside of the normal stock/bond portfolio)

Typical asset allocation for an institutional portfolio

Equity 40%
Fixed Income 30%
Real Estate 15%
Inflation Protection 15%

Breakdown of the capital portion

The strategic allocation to equity could be broken down into the following subclasses:
Beta Drivers – 60%
• Passive equity
• 130-30
• Improved index equity

Alpha Drivers – 40%
• Private capital
• Troubled debt

Convertible bonds have a hybrid structure that is a mix of equity and fixed income securities, so they can be included in either the equity or fixed income category.

fixed income portfolio

This section of the portfolio can also be divided into alpha and beta drivers. The fixed income portfolio may be allocated as follows:

Beta Drivers – 60%
• US Treasuries.
• Investment grade corporate bonds
• Agency Mortgage-Backed Securities

Alpha Drivers – 40%
• Convertible bonds, high yield bonds and mezzanine debt
• Collateralized Debt Obligation (CDO) and Collateralized Loan Obligation (CLO)
• Fixed Income Hedge Fund Strategies, Fixed Income Arbitrage Relative Value, Distressed Debt

15% Inflation coverage

This is an investment strategy that aims to provide a cushion against the risk of a currency losing value. Other investments can produce returns that exceed inflation, but inflation hedging is specifically designed to preserve the value of a currency. Here’s how you can split up the inflation-hedge portion of your portfolio:

TIPS (Treasury Inflation Protected Securities) 20%
Infrastructure 20%
Commodities 20%
Natural resources 20%
Inflation-oriented stocks 20%

15% real asset allocation

Real estate is a liquidity-limited form of investment compared to other investments, is also capital intensive (although capital can be raised through mortgage leverage), and is highly dependent on cash flow. Due to these realities, it is important that this section of the portfolio does not constitute the majority of the portfolio. You could structure your real estate portfolio as follows:

Real Estate Investment Trusts (REITs) 40%
Direct investments 30%
Real estate private capital 15%
Specialized 15%

However, it is very important to note that option-like securities are very risky and should be used with extreme caution. This is what brought down the UK’s oldest commercial bank and is what Warren Buffet describes as “financial weapons of mass destruction”. Portfolio management should be done as conservatively 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 the alpha seeking positions that an institution can pursue and have a waterproof internal control system to curb dishonest trading.