Not quite clear on how can you earn alpha (over the benchmark) while trying not to deviate from the benchmark performance? They seem mutually exclusive…
And, when talking about market neutral trading, do they refer to systematic risk and the equity risk premium synonymously? They say that the appropriate benchmark is the risk free rate for a long-short, mkt neutral strategy, which implies the MRP and beta as a whole are neutralized. However, beta and the general MRP from investing in equity mkts are not the same thing. So do they refer to beta as the risk measure for equities?
alpha over the benchmark is earned by investing in securities you consider are undervalued, and by walking away from overvalued securities (buy low, sell high).
That way individual sectors in your portfolio outperform the same sectors on the benchmark - and you earn overall alpha. However doing this approach would insert tracking risk into the Portfolio (std deviation of portfolio returns over the benchmark returns). So the attempt would be to bring in alpha (excess return) while trying to minimize the tracking risk simultaneously. That would be effort of optimization.
can you explain what you are trying to ask in your second question? I am not clear on what you are trying to ask.
beta is a measure of risk that cannot be diversified away. (cov(rp, rm) / var(rm)).
A long-short mkt neutral strategy is said to have no systematic risk and therefore the appropriate benchmark is the risk-free rate. However If a correct pairs trade only eliminates systematic risk (beta), doesn’t that leave the rest of the equity risk premium? Beta and the equity risk premium are not the same thing, right? How can the benchmark be the Rf rate if the mkt neutral strategy only eliminates systematic risk? This makes me think that the book is basically rreferring to beta (systematic risk) as representative of the equity risk premium as a whole.
long short market neutral strategy = invest in long and short securities in the same industry.
since the long + short are in the same industry - any systematic risk is eliminated -> kind of like + (long) on one side being nullified by - on the other side (short). Also the $ amounts on the long and short investment are equal. (that is the market neutral piece).
long short = desire for 0 beta.
since they are in the same industry / sector - your benchmark would be the risk free rate.
But what about the remaining equity risk premium priced into the stock? The long-short eliminates the beta/systematic risk component but not the ERP, no? Rf + B (ERP - Rf). Beta does not represent the total equity risk, it’s just the specific exposure of the industry the stock occupies. A Rf benchmark means there’s no remaining equity premium. So by that arent you suggesting that beta and ERP are the same?
In a beta-alpha separation strategy, it says you can use an index in, for example, the S&P 500 to achieve beta exposure. My question/point is: beta represents a relationship btw a security/investment and the market itself (eg S&P 500) - not the exposure to equities in general. beta is something different than just the equity risk premium, which can be represented by S&P returns less Rf. here however, it sounds they’re suggesting that beta represents the return from investing in equities in general. If you get beta through the S&P index, is that effectively saying that your beta=1?
and what is anything multiplied by zero? Zero. Therefore in your equation you get Rf+0(whatever-Rf)…so multiplying thru by zero and you are left with the Rf rate.
Yes, I get that. I suppose I was looking for confirmation though. It sounds that the book treats beta as representative of equity market risk in general, even though beta and the equity risk premium are distinctly different, no?
Yes, beta is distinctly different from the equity market premium. Beta measures the risk – volatility of returns – attributable to overall market fluctuation. The equity risk premium is not a measure of risk; it’s a measure of the compensation required to take on additional risk (the volatility of returns of the market). Beta measures how likely (and to what extent) you are to be injured in a firefight; the ERP is your hazardous duty pay.
In enhanced indexing you are trying to deviate from the benchmark performance; just not too much and only in specific directions. You may change the duration of your portfolio to be slightly different from that of the benchmark, or your sector concentration to differ slightly, or your credit quality to differ slightly. And you hope that all of your slight deviations together will produce positive alpha.