Bicycle races, such as the Tour de France, amaze some and confuse others. Most will appreciate the strength, ferocity, endurance and desire to win in the peloton (the colorful pack of race competitors), but what's this about competitors helping one another during a race? By taking turns leading and drafting in the slipstream behind other riders, a competitor can preserve up to 40% of his or her energy. Gaining and keeping this advantage, and knowing, based on the rider's strengths, when to make his or her move, is typically the difference between finishing and winning. The solo rider – determined, head down and working hard – is at a severe disadvantage.

Asset managers are in a competition which demands many of the same qualities to win. As in cycling, some will insist on or be left riding solo. Others will seek collaborations at different stages of the race – preserving resources by drafting off the skills of others – and will choose when and with what tool to make their move in pursuit of victory.

To date, the collaborations of asset managers have mostly been geared toward boosting distribution or filling narrow gaps in a fund lineup. This essay introduces the concept of alpha/beta separation, and argues that more fundamental but less obvious forms of collaboration are available to the asset manager seeking more robust alpha production and greater efficiency.

Alpha/Beta Separation
There is much discussion today about the separation of alpha and beta. For the purposes of this essay, alpha is defined as excess return attributable to a manager, and beta refers to the return of an underlying benchmark. The benefits of separating the responsibilities for alpha and beta generation are compelling.¹

• Greater Alpha Production from Active Managers – Removing constraints that inhibit alpha generation, including the responsibility for beta production (remaining close to a benchmark), and barriers to taking positions on both the short side and outside the benchmark's universe of securities.
• Better and Cheaper Beta Production – Gaining complete market exposure at the lowest possible cost.
• Reducing Implementation Costs – Compensating alpha and beta managers in a manner consistent with their roles, and reducing transaction costs and volume.

Implications for the Asset Manager
The move by investors and consultants to separate alpha and beta ruthlessly exposes a manager's strengths and weaknesses. Gone forever are the days when an asset manager can happily collect active fees for passive investment performance. Asset management firms that accept this premise are faced with three simple yet challenging self-assessments:

• Are we an alpha or a beta manager?
• Where do we honestly possess an “edge” over other managers?
• How should our resources be allocated to protect our edge?

The alpha-beta manager question will be the simplest for most to answer. Most investment managers consider themselves active managers, so we will assume that most managers will identify themselves as alpha managers.

If the alpha manager's “edge” is defined as sustainable alpha production, performance can be attributed though any number of methods or software packages (i.e., Barra, etc.). The source of this performance may be some combination of exceptional talent, access, research, information sources and trading. It also may be limited to certain asset classes and even sectors or sub-sectors. Wherever the manager lacks an edge, there are three choices: 1) the manager can continue to offer weak product and risk sustained redemptions and reputational risk, 2) where permitted, the manager can port its proven alpha source onto beta where its alpha ability is absent (portable alpha), or 3) it can buy it from others (sub-advisory). In honestly defining its edge, the alpha manager may find that it can leverage its best alpha sources in other ways, including opening up new and higher margin revenue streams with concentrated, alpha-extension (i.e., 130% long, 30% short) and even absolute return versions of the original strategy.

Resources should be focused on protecting and developing the firm's “edge.” This might include strengthening support given to portfolio and analyst teams distracted by portfolio construction, trading and projects. Regarding resources focused in areas outside of the firm's edge, consider the following:

• If a manager's edge resides in growth equities, what contribution do value equity portfolio managers, analysts and support staff make to the alpha firm's sustainable alpha production and profitability?

• What percentage of the alpha manager's portfolio managers and support staff contribute not to high-margin alpha production, but really to low-margin beta production, containing tracking error in portfolios?

In the first case, those firms that aspire to fill all the style boxes, but only realistically generate alpha in some of them may elect to hire sub-advisors to repair struggling products and improve efficiency. In the example above, the manager with a robust alpha capability in growth equities could seek and retain a value specialist to sub-advise its value product line – helping the firm retain at-risk assets, improve performance and potentially build assets in these funds. The sub-advisory fees would be rationalized based on direct costs that can be eliminated and revenue that can be generated from asset retention and growth.

In the second case, those firms seeking maximum alpha production and efficiency will be intrigued by the proposal that their beta production can be outsourced. Hiring a beta sub-advisor may be valuable in several areas, including the following:

• Equitization: Exposing uninvested cash to the market through synthetic, or derivative, vehicles such as futures and swaps.
• Strengthening Weak Spots: Incorporating passive components in select parts of a balanced fund, perhaps replacing poorly performing active strategies or lack of product in certain asset classes.
• Building Dedicated Market Exposures: An example would be the fixed income manager whose alpha strength is in mortgages, and whose weakness is in credit, choosing to focus its resources on mortgages and hiring a sub-advisor to build and maintain passive credit exposure.
• Passive Implementation: An international equity team that generates its alpha by selecting countries or sectors, rather than individual stocks, has the opportunity to use the beta manager's passive country and sector exposures to more efficiently implement the strategy.
• Portable Alpha: Engaging a beta manager that potentially can play several roles complementary to the alpha manager, including building market exposure, shorting out market exposure related to a long-only alpha strategy, and managing the cash and collateral associated with futures positions.
• A Literal Separation of Alpha and Beta: Separating portfolio construction so that core strategies allocate to both an alpha and beta portfolio – the alpha portfolio being the firm's absolute return strategy, and the beta portfolio being manufactured by a beta manager at the lowest possible tracking error and cost.

Choosing to buy alpha and/or beta in certain places is less an admission of weakness and more an acknowledgment of what is core and what is secondary to a manager's pursuit of victory, as defined by sustainable alpha production and efficiency. The decision to buy versus build may be temporary. Buying may simply be the quickest, easiest and least expensive way to gain an advantage at different points in the race. New alpha sources and beta production resources can always be developed and used later.

SSgA's sub-advisory unit was established to build working partnerships with other asset managers, enabling them to tap into the firm's alpha and beta competencies as needed.

Summary
Competition among asset managers is no less fierce than what exists among racers in a bicycle peloton. Everyone wants to win. Each competitor brings a different skill set – some specialize in generating alpha, others produce beta. The best managers protect and develop their strengths; they look for opportunities to conserve energy (such as drafting off the skills of others where appropriate) and know exactly when and how they will make their move to cross the finish line ahead of the pack.

¹For a complete discussion on the concept of alpha/beta separation, readers should refer to: Clarke, deSilva and Thorley, “Portfolio Constraints and the Fundamental Law of Active Management,” Financial Analysts Journal, October 2002; and, from ssga.com:, Brandhorst, “The Benefits of Separating Portfolio Management of Alpha and Beta,” March 2005, Calvello, “Best Practices for Portable Alpha,” April 2005, and Kohler, “Implementation Guide for Portable Alpha and Efficient Beta Exposure,” December 2004.

This material is for your private information. The views expressed are the views of Michael Dalis only through the period ended August 23, 2006 and are subject to change based on market and other conditions. The opinions expressed may differ from those with different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results.

Posted On: August 24, 2006