Blending alpha, factors and index
Our empirical work can be applied in a variety of contexts, no matter the investor's portfolio construction preference. A few key factors will shape the alpha-seeking decision. We present examples to show how our framework helps make this happen:
- Allocating the alpha risk budget: Investors often determine their broad market allocation in a first step. The second step seeks to generate active returns while sticking to the overall beta structure. The active returns will come from a combination of factors and alpha. How much capital should be allocated to different alpha sources? Our alpha estimates can help investors allocate efficiently by highlighting what alpha and IR the different alpha sources might deliver.
- Achieving the desired mix of returns: Once the alpha budget is allocated to alpha-seeking managers, the additional returns from manager static tilts could disturb the targeted mix of macro and style factors. Our framework makes clear that the implementation phase is more than just a decision to allocate to managers. The overall blend of alpha-seeking, factor and indexing strategies should be constructed to respect the target SAA. A holistic perspective is needed.
- Maximising the governance budget: The process of searching for alpha-seeking managers, assessing their performance and reshuffling these exposures takes time and money. Many investors have limited resources for these activities. That is why investor beliefs matter - whether they have the research and resources to oversee alpha-seeking managers and consistently achieve alpha. Investors with a limited governance budget may opt to oversee just a few alpha-seeking managers - or even to keep the entire portfolio in index products.
The design phase of our framework demands managers who provide alpha, while the implementation phase accounts for any factor exposures managers bring along. Alpha-seeking strategies with higher expected alpha, net of fees, should be part of a portfolio regardless of the market and factor exposures within their active returns. Investors should not simply filter out managers with high factor exposures.
Our framework is closest in spirit to Waring et al. (2000). As we have shown, our holistic portfolio approach focuses on the major asset classes in blending alpha-seeking, factor and indexing strategies. We show our framework again below and now demonstrate its application, starting with a fixed income portfolio.