I’m a little confused about the concept. The CFAI text explains that an investor seeking beta for an equity index could use a fixed income manager for alpha generation and wind up with equity beta+ fixed income alpha. What confuses me is to consider using beta for the S&P which is expected to return, say, 10% with a fixed income manager for alpha that is using an index expected to return 3%. Even if he generates 2% alpha, the investor would have been better off with the pure beta play. For example, say he allocated 80% to the S&P and 20% to the FI manager, his total return would be (10%*0.8)+(5%*0.2)= 9%; where he would’ve been better off investing everything in the S&P getting a 10% return. What am I missing with this. Would futures be used or some type of leverage on the FI manager?
i’m confused as to where you got this information from. The curriculum talks about alpha-beta separation within the context of an equity asset class (earning alpha through FI is not something I remember reading). Can you provide a section number and chapter?
@ Ink, The Curriculum in Section 7.3 specifically says Alpha and beta separation can be applied to different classes of assets or different markets (portable apha) etc including bond markets. I think the idea is to invest though multiple managers say, an index tracking manager - Beta investing and invest in another asset class - maybe market neutral hedge /long-short fund manager with zero exposure and therefore Apha investing. The long–short manager could also have been a bond manager.That way you have separated your Beta and Alpha portifolios.
thanks broadex,
i was wondering if you could provide a few more details about how you can have a long-short manager to manage your alpha with bonds? Do you use, as tyler suggested, futures contracts to do that? Sort of sell futures for overvalued bonds in order to decrease exposure and buy futures for undervalued bonds in order to increase exposure?
It sounds like you may be referring to the Synthetic approach to enhanced indexing strategy.
In this case, you gain exposure to a market via derivative and actively manage your remaining cash, usually through short term fixed income. Below is a detailed description I found via google on how this makes money:
The second approach that is becoming more widespread - the synthetic strategy - uses derivative contracts in an attempt to outperform the returns of the index. A common form of synthetic enhanced indexing involves owning futures, which is in a sense a “buy now, pay later” approach. For example, margin rates for S&P 500 futures currently run about 5% of the total contract value. The remaining 95% of the investment can then be placed in short-term fixed income investments. The trick is to outperform the London InternBank Offered Rate (LIBOR) with the fixed income investments. LIBOR is the financing rate associated with S&P 500 futures, so returns above LIBOR lead to enhanced performance.