13 May 2020 3 min read

Scrumptious strategies: diversified alpha

By John Southall

A few recipe guidelines that can help investors prepare more balanced portfolios



Building a robust portfolio is rather like making a mouth-watering meal. The benefits of a well-balanced main course, otherwise known as the diversification of beta, are generally well appreciated. However, getting the pudding just right – the diversification of alpha – is often neglected.

In this blog, I explore a few recipe guidelines that can help investors prepare more balanced portfolios when it comes to harvesting investment skill.

Tasty tactics

Suppose you decide to cook yourself a meal, with a main course and a dessert. There are a few high-level decisions to make before you get started, such as the balance of ingredients in both courses.

Similar considerations apply to portfolio construction, where your beta (market exposure) is the main and your alpha (investment skill) is the dessert. The mix of ingredients within the main and the dessert should, pretty much, be independent decisions. How many strawberries you have with your cake shouldn’t have much to do with how many potatoes you have with your roast. Similarly, just because a lot of your market risk is dominated by equities (as in the typical portfolio) doesn’t mean to say equity alpha should dominate your active risk budget.

Appetising alpha

A holistic perspective breaks the dependence of the alpha split on the underlying beta exposures. This leads to the idea of portable alpha, where alpha is separated from beta.

The trouble is that, rather messily in asset management, the dessert tends to be mixed with the main. There are good practical reasons for this. For example, the expertise to generate alpha usually sits with the same manager giving you market exposure. It’s easy for the manager to short a stock they don’t like (up to a point) relative to the market just by holding less of it.

Realistic recipes

Admittedly, portable alpha is largely a theoretical ideal. But there are some sensible steps investors can take to diversify and harness alpha:

(1) Allocate and diversify the alpha budget. Investors should avoid one type of alpha dominating; the best puddings don’t use a single ingredient.

(2) Source skill from those who have the resources and ability. This can involve a mix of economists, strategists, analysts, and portfolio managers who can also implement trades efficiently (for example, because they have the scale to reduce costs). In other words, use quality ingredients.

(3) Don’t neglect the macro; don’t leave key ingredients out. Macro alpha can be cumbersome for many investors to access directly. They may not be close enough to the market or have the speed (given governance structures) needed to capture opportunities. One option is to access macro via a dedicated fund, or to use a diversified multi-asset strategy that includes dynamic asset allocation.

(4) Don’t neglect alpha from lower-risk areas. It’s tempting to think of liability-driven investment (LDI) as a zero-risk zone, whose sole purpose is to match liabilities. But this isn’t necessarily the right strategy from a holistic perspective. If you are seeking rewarded risks elsewhere in your overall strategy, it can make sense to seek alpha opportunities in low or zero beta areas such as LDI.

(5) Use genuinely active managers; don’t pay for a non-existent dessert. Investors shouldn’t pay active fees for passive products. Similarly, one should not be paying discretionary fees for systematic exposures accessible through factor-based funds.

Finally, some quantitative analysis can help. Think of this as something like a calorie counter: quants can help manage the whole meal and save you from getting indigestion…

John Southall

Head of Solutions Research

John works on financial modelling, investment strategy development and thought leadership. He also gets involved in bespoke strategy work. John used to work as a pensions consultant before joining LGIM in 2011. He has a PhD in dynamical systems and is a qualified actuary.

John Southall