2.2.3 Consequences from the separation of Alpha and Beta
To allow an improvement of the features of a portfolio, it is
vital to divide it into two elements which are managed in different way to
achieve the goals of each component. I speak about the separation of alpha and
beta. In other words, this is the separation of market returns and stock active
managers return in evaluating performance. Beta is delivered by the core and
Alpha by the satellite. This evolution can be considered as the main
industry-changing in investment management.
As I said before, this division allows to
avoid the long-only constraint, and by consequent to give more flexibility to
managers. With the core/satellite approach, active managers can have short
positions, use leverage, and they don't have to track a benchmark. The last
point
10
allows the manager to be more focus on their primary goal of
taking advantage from market inefficiencies to produce more alpha. Academic
research show that the constraints from the traditional portfolio construction
reduced the expected excess return, especially the long-only one7 .
Moreover, the opportunity of borrowing grabs a better risk management to the
portfolio. Active managers can use leverage to achieve an accurate level of
risk. For instance to increase risk, they can borrow to buy more of the optimal
portfolio. But the ability to use leverage has a side effect. For instance,
shorting stock can have unlimited losses. The large potential downside risk
mitigates the effectiveness of the risk management.
Another good point is that the distinction between passive and
active strategy allows to build cost effective portfolio. Than the traditional
construction portfolio, this approach needs to hire less managers (must have
only one for the passive core) and is easier to monitor (less rebalancing for
instance) so the associated costs are lower. Moreover, no extra money is spent
to only obtain beta. This saving allows investor to spend higher active
management fees in the search for «pure» alpha.
Finally, one last benefit of this approach is about the
taxation. This separation put on one side the tax-inefficient trading
activities and on the other side the tax-efficient benchmark tracking. So,
investors can enjoy a pre-tax Beta, and is subject to tax if his active
investment produces positive returns. The market exposure is not anymore
subject to tax like in a traditional approach, therefore this separation allows
to avoid the tax hurdle8 . This is the fact that an active manager
has to produce enough excess pre-tax to offset the tax consequences of active
management. The goal is the outperformance of the benchmark on an after-tax
basis.
7. Clarke. Roger, Harindra de Silva, and Steven Thorley,
"Portfolio Constraints and the Fundamental Law of Active Management",
Financial Analysis Journal, September/October 2002.
8. Jeffrey. Robert H., and Robert D. Arnott, "Is Your Alpha
Big Enough to Cover Its Taxes?", The journal of portfolio management,
Spring 1993.
11
Moreover, this approach leads to less turnover events (e.g.
infrequent rebalancing), by consequent the incidence of tax decreases.
One more thing about the taxable environment, the core can be
tax managed. The tax-loss harvesting strategy has to be applied. That consists
to sell benchmark stocks that have decrease in value while keeping those that
have appreciated. The short- or long-term losses from the sales can be netted
against gains from satellite portfolios. Therefore, the investors can absorb
some capital gains tax liability. The use of this strategy allows to get a
higher after-tax return than a non-tax managed core. To implement this
strategy, an investor has to have a willingness to sell stocks which do not
perform well, and a willingness to hold appreciated stocks. Note that this
strategy can be run while keeping a low tracking error versus the benchmark.
Overall, the separation of alpha and beta allow the active
manager to create higher return per unit of tracking error.
This division has not only good side effects. Now, active
managers have only one goal. But in the traditional portfolio construction, the
benchmark constraint allowed to monitor their behavior; they needed to have a
broadly diversified portfolio to get beta. So this evolution gives some freedom
in the large amount of investment possibility to the managers, and takes some
control from the investors.
Furthermore, Investors can have some difficulty to get
information about his active holding. Because some component of the portfolio
like hedge funds, does not report frequently the portfolio holdings and their
results. The investors can lose some transparency with this approach.
Another point states that some investment of the satellite
portfolio are blocked for a long period of time. For instance, hedge fund can
require investors to stay in the fund during a
12
minimum period of time, like one year. So an investor can see
his portfolio liquidity decreases with a core/satellite approach.
We can see that the benefits from this separation largely
overcome the side effects. By taking into the previous points and the need of a
new alternative in portfolio construction, we can expect that this approach is
pretty used in the financial world.
| 
