Don’t confuse alpha strategy with asset allocation beta

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Do you know where the performance of your strategy comes from?

It’s a simple question with a simple answer, but it’s always easy to get sidetracked by faulty analyses. Fortunately, there is a simple solution.

The right way to break down returns is to first recognize that asset allocation generally plays a large role in driving results. A simple example: a portfolio made up entirely of equities is likely to outperform an equally weighted mix of equities and long-term bonds. The main reason, sometimes the only reason: the asset allocation beta of the 100% equity portfolio has a higher risk profile compared to the 50/50 equity/bond strategy.

If the stock-only portfolio generates an annualized total return of 8% versus 5% for the 50/50 strategy, the extra 3 percentage points in the former can be considered asset allocation beta. In other words, by changing the asset allocation (removing bonds and increasing exposure to equities), the equity-only strategy achieved a higher return based on the superior performance of a specific asset class. It is not alpha since anyone can exploit the results with a portfolio change without forecasting or analysis.

So where does true alpha come in? Let’s run a simple example for illustration. Imagine that you are considering a 60/40 stock/bond strategy as an investment. A fast-talking fund manager comes along and offers an alternative, with the following rules:

When the growth factor tranche of the equity market outperforms the value component, the 60% allocation to the broader stock market – SPDR S&P 500 ETF (SPY) – is transferred to a growth fund: SPDR Portfolio S&P 500 Growth ETF (SPYG). If growth is underperforming, SPY is used for equity allocation. In both cases, a 40% allocation is maintained via iShares Core US Aggregate Bond ETF (AGG). (Note: In this example toy, I’m using SPYG and SPDR Portfolio S&P 500 Value ETF (SPYV) to generate the tactical signal.)

Turns out, the SPY vs. SPYG switch tactical strategy has outperformed the standard 60/40 mix since 2015. The manager presents the chart below and declares himself a genius. He concludes by noting that his strategy outperformed with an annualized total return of 10.7% versus around 9.0% for the 60/40 portfolio. That’s an additional 170 basis points of performance, he happily notes.

Wealth indices - Strategy - 60/40

Not so fast, you shoot back, and keep pointing out that part of the extra return is tied to the beta of the asset allocation. To be precise, naïvely dividing the allocation to the two equity funds – 30% in SPY and 30% in SPYG – and combining it with a bond allocation of 40%, there was an improvement over the yield 60/40 without using a tactical signal: the asset allocation beta mix gained 9.9%. (Note: All results are rebalanced to target weights at the end of each calendar year.)

Wealth Indices - Strategy - AA Benchmark - 60/40

If we break down the strategy’s total return of 10.7% (or the equivalent of 1,073 basis points), it becomes clear that about half of what the manager describes as alpha is only reality than the asset allocation beta. That is, the additional return obtained by simply holding the defined opportunity with a target combination of 30%/30%/40% via three ETFs in this case: SPY, SPYG and AGG.

Breakdown of annualized total return

What can you do with this information? You might wonder if the extra ~85 bps of genuine alpha is worth the risk of the manager’s tactical model? No model is perfect and so it is crucial to understand how the model works and decide if you are comfortable with its logic and the possibility that it could produce negative alpha at some point.

Indeed, you might decide that asset allocation alpha is more reliable, in part because it doesn’t require any special skill or talent to generate.

The most important point is that each active strategy has an asset allocation beta counterpart based on a passive mix of the opportunity set. Depending on the strategy, trying to improve the beta of the asset allocation with an active strategy may or may not be prudent. The first step is to break down the total return of a strategy into its constituent parts.

Original post

Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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