Wealth Manager

The most conspicuous evidence of the risk
metric’s muscle is the explosive rise of ETFs,
the majority of which can be thought of as
exchange-listed celebrations of beta’s fundamental
principles. Focusing on the risk/return
profile of “the market,” in other words,
has never been more popular.

Beta, of course, is the offspring of the Capital
Asset Pricing Model, which laid much of
the academic groundwork for index funds.
CAPM’s instruction for looking at securities
and portfolios through beta-colored glasses is
a quantitative statement that return and risk
are related in a generally predictable, linear
way. Mathematically, the model declares that
higher returns come only with higher risk. To
cut to the chase: Investors are rewarded primarily
for market risk— i.e., beta—over time.

The fact that active managers have a hard
time beating a relevant index suggests that
investors should think twice before ignoring
CAPM. Nonetheless, the model and the
other theoretical foundations that make up
what’s called modern portfolio theory (MPT)
have long suffered intellectual assault. That
includes the charge that investors aren’t fully
rewarded for beta risk as CAPM predicts.
Higher betas, some empirical studies show,
don’t necessarily bring higher returns; meanwhile,
lower betas don’t always lead to lower
returns. As a result, regressing return against
beta risk may show that the capital market
line is flat rather than upward sloping, as per
CAPM.

To the extent that CAPM stumbles as a predictor
of returns, two basic theories compete
for explaining the shortfall, according to Prof.
Eugene Fama. One comes from the behavorialist
school of economics that argues that investors
go to extremes by paying either too
much or too little for stocks relative to what
CAPM predicts. A competing theory is that
CAPM is too simplistic for the real world and
therefore, investors need a more nuanced
pricing model. In fact, academics have built a
number of alternative models over the years.
CAPM was never intended as a forecasting
tool for securities prices per se. Rather, its raison
d’être is one of deciphering relationships
between variables with an eye on establishing
a framework for building portfolios and analyzing
securities, in reference to the total market
portfolio, which goes far beyond equities.

Nonetheless, some conclude that the various
indictments of CAPM represent a death
sentence for beta. Yet the late Fischer Black,
who helped revolutionize finance with the
design of the Black-Scholes Option Pricing
Formula, saw it differently. In 1993, Black
wrote that beta is a valuable investment tool
if the capital market line is as steep as CAPM
predicts. But if the line is flat, CAPM is even
more valuable, he added.

Black reasoned that beta isn’t wrong; rather,
the real world frictions make it difficult to
fully exploit beta. That offers opportunities
for savvy investors to capitalize on the inefficiency.
Burton Malkiel echoes the point in
the latest edition of his book, A Random Walk
Down Wall Street (Norton, 2007), advising that
investors “should scoop up low-beta stocks
and earn returns as attractive for the market
as a whole but with much less risk.”

In spite of the attacks, beta still holds enormous
sway over the way investors think.
Financial historian and consultant Peter
Bernstein devotes his latest book to profiling
several of the more notable examples of
the expanding uses of MPT (or, Capital Ideas,
as he brands it) in recent years. “Despite all
this turmoil, the applications of Capital Ideas
have developed into orthodox operating procedures
in the daily management of investment
portfolios and trading activity in the
financial markets all around the globe,” he
writes in Capital Ideas Evolving (Wiley, 2007).
A key reason: The basic trade-off between risk
and expected return still “infuses all investment
decisions,” he opines.

A beta-informed view of the capital markets
seems likely to endure, but that doesn’t
mean that its advocates are forever stuck in
yesteryear. The risk metric’s uses evolve, albeit
as a continuum of change that links the
original beta research of the past to the leading-
edge applications of the present.

One example is grafting beta-oriented concepts
onto asset allocation strategies. This
seems reasonable if you consider that CAPM’s
flaws are reportedly minimized in the context
of broad portfolios compared to individual
securities analysis. Several studies over the
years suggest that broader is better for indices
and strategies when it comes to finding
relevance between beta and the real world.
Among those who walk this path of
reasoning is P. Brett Hammond, chief investment
strategist at TIAA-CREF Asset Management,
which oversees more than $400
billion. Beta, Hammond told Wealth Manager
in a recent interview at the firm’s New York
headquarters, is hardly dead. In fact, in a recent
research paper, Hammond takes a fresh
look at beta-inspired analytics for modeling
multi-asset class portfolios that add alternative
assets—such as hedge funds and venture
capital—to conventional portfolios of stocks
and bonds.

The paper, “Reverse Asset Allocation: Alternatives
At The Core,” draws on an analytical
framework that was developed at
TIAA-CREF by Martin Leibowitz (now with
Morgan Stanley) with assistance from Hammond
and others. It provides a strategy for
comparing the investment opportunity set
in terms of adjusted betas—adjusted in the
sense of looking at asset classes through a
U.S. equities prism.

Expected returns of hedge funds and government
bonds, for instance, are measured
relative to the redrawn capital market line
using U.S. equity beta and the “risk-free”
return of Treasury bills. To the extent that
an asset class offers expected return above
the new capital market line, the return premium
is considered structural alpha. Unlike
the standard definition of alpha, which is a
function of active management, structural
alpha in this case is a premium generated
from diversifying into passively managed
asset class betas beyond domestic equities.
For instance, the chart below (for illustrative
purposes only) shows that REITs have
roughly half the expected beta of the U.S.
equity market, but offer roughly 200 basis
points of expected structural alpha.

Click for larger image

One reason for looking at asset classes
this way is that it reframes the analysis in
terms of expected returns and risk relative
to domestic stocks. For good or ill, most investors
use domestic equities as a reference
point. Adding alternative asset classes typically
centers on how those additions will
modify a conventional stock portfolio.
Hammond’s revised beta formulation
maintains a reference point for how investors
behind the reverse asset allocation strategy
are U.S.-equity oriented, the foundation
starts with alternative asset classes as core
holdings. That’s the opposite of the traditional
approach; thus the label “Reverse
Asset Allocation.”

Why flip asset allocation on its head? Because
the conventional process of starting
with domestic stocks and adding alternatives
can lead to extreme allocations when
using portfolio optimization techniques—
extremes that few investors are willing to
tolerate, says Hammond. “Reverse Asset
Allocation” offers a substitute methodology
that keeps asset allocations practical (in
terms of what investors will tolerate) while
staying true to MPT’s ideas.

In fact, looking at beta from different perspectives
has been a lively line of inquiry for
years. A recent example is “A Factor Approach
to Asset Allocation,” a 2005 paper from The
Journal of Portfolio Management. Building on a
long history of research, the paper identifies
global market factors “that can be used to
diversify the exposures in a portfolio.” Examples
include earnings yields, market premium
changes, real interest rates and spreads
in short-term interest rates across currencies.

The authors, who work at Los Angeles money
manager Analytic Investors, note that these
and other global factors have returns that are
uncorrelated with one another. Introducing
these factors into conventional stock/bond
can improve the overall risk-adjusted profile.

"What's striking when I talk to clients is
that everyone’s so concerned with the equity
market,” says Harindra de Silva, one of
the paper’s authors and the president and a
portfolio manager at Analytic. “But there are
10 other sources of return. If you’re so concerned
about the [equity] market, that probably
means you have too much risk allocated
to that one source of return.” That suggests
looking for alternative sources of returns, including
the risk factors in the paper, he says.

“What we call factors are basically other
betas,” de Silva continues. Allocating part of
a portfolio to these other betas in a systematic
way helps minimize equity risk while
tapping equity-like returns, he argues. “The
basic idea is that there are these [alternative]
systematic sources of return.

No less is implied by MPT’s founding document
—Dr. Harry Markowitz’s “Portfolio Selection.”
The 1952 paper that inspired CAPM
counseled that an efficient portfolio—one
that maximizes return for a given level of
risk—is driven by an enlightened mixing of
assets with low covariance. The initial presumption
was that the risky assets are stocks,
although refinements to the theory have expanded
the playing field to include various
equity and bond indices along with so-called
alternative betas such as commodities, currencies
and beyond.

What’s old is sometimes new in portfolio
theory, and very much alive. O death, where
is thy sting?