New directions in asset allocation

Traditional asset allocation thinking by institutions was that equity exposure should dominate; and certainly many long-term studies pointed to the return advantages of equities versus other asset classes. However, we have seen a fundamental shift in asset allocation thinking prompted by the three-year bear market in equities from 2000 – 2002 and a substantial decline in interest rates. There is a movement away from equities as the sole source of return generation, a search for better beta diversification in the policy mix.

For all types of institutional investors, a desire to rely less on equities generated greater interest in alpha as the new source of return opportunity. Hedge funds became popular as the ultimate expression of alpha, and manager flexibility and transportable alpha emerged more prominently as a way of harnessing returns. The bear market also prompted investors to seek better beta diversification in their policy mix. In addition to alternatives like hedge funds and private equity, we are also seeing growing interest in unconstrained or “go anywhere, do anything” portfolios in a long-only format. Like “traditional” alternatives, these nonbenchmark-oriented approaches emphasize active risk to a greater degree than benchmark-focused.

I think a really pervasive decoupling of alpha and beta is still in the future. You could look at the use of hedge funds as a kind of separation of alpha and beta. A fundamental, desirable characteristic of a hedge fund is that the alpha risk taken is enough to offset the beta risk. So if the beta performance is down but the alpha risk is performing well, you can overcome the beta risk, because the alpha and beta risks are more fundamentally balanced.

As a result, there is willingness by a growing number of institutional investors to redefine their relationship with fund managers so that it’s not about beating a market-related benchmark, but rather taking on the institution’s overall investment objective. CRICO/RMF asked our fund managers to put together portfolios that target a certain level of return with the minimum risk possible and fund managers will find out that a significant amount of the total risk is active risk. It makes sense that you can get a better return-to-risk ration with a well-constructed alpha strategy than with a well constructed beta strategy.