Pursuing Alpha In A Well-Diversified IRA

By Rich White AAA

Alpha has become one of the hottest investment concepts of the modern era, despite the fact it is often misunderstood by investors and sometimes misused by the investment industry. For example, you may hear investment managers (especially hedge funds) talk about an "alpha-generating fund". You also may see examples of funds that point to their benchmark-beating performance as evidence of the alpha they are creating. Fortunately, this concept is simpler than it sounds and, when implemented in a well-diversified IRA portfolio, can have tremendous benefits for investors who take the time to learn how to use it.

What's Alpha?
Alpha is a risk-adjusted measure of performance. It takes the volatility of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha. (For background reading, see The Uses And Limits Of Volatility.)

If the definition of alpha is a little confusing, it may be because for the purposes of measuring investment performance, alpha can only be evaluated in combination with another Greek letter, beta. For any given investment or investment portfolio, beta measures historic volatility compared to the market as a whole. The higher the volatility/risk, the higher the beta. (To read more, see Beta: Know The Risk and Bettering Your Portfolio With Alpha And Beta.)

For example, the market as a whole (often measured by the Standard & Poor's 500 Index) has a beta of 1. So, a mutual fund with a beta of 0.8 can be expected to demonstrate 80% of the market's overall volatility. Alpha is effectively the component of risk-adjusted return that is not explained by beta, and a positive alpha indicates successful risk-adjusted performance. Once you understand these basics, three key points about Alpha should become clear:

  1. Alpha can't be projected or promised, and it isn't "baked-in" to any given investment or strategy. It can only be measured historically, by looking back at risk and performance together. The historic time period chosen for the measurement is important and should be known.
  2. When portfolios have risk profiles that are equal to or above the market's average beta (1), it is difficult to generate alpha consistently over time because markets are competitive and somewhat efficient. A manager who produces a beta above 1 must consistently beat the market average just to produce an alpha of zero, indicating that no risk-adjusted value has been added or subtracted. (For more insight, check out Does Your Investment Manager Measure Up?)
  3. A more effective way to generate consistent alpha is by aiming for consistent performance in a diversified low-beta portfolio. To build low-beta portfolios, investment managers combine asset classes that have low correlations with each other. This strategy can work because the investment correlations of asset classes are more persistent and predictable than investment returns.

Do-It-Yourself Alpha in Your IRA
The modern investment world at times makes alpha seem out of the reach of investors with modest assets or limited risk appetites. This aura has been perpetuated by hedge funds aimed at wealthy investors and the Greek letters inserted in investment marketing literature. However, if you keep in mind that alpha can only be measured retroactively (historically) and can best be generated by low-volatility portfolios, you will understand how accessible alpha-seeking strategies can be. Let's take a look at how to increase the alpha of an IRA of virtually any size.

Hypothetically, let's begin with two assumptions, neither of which may always be true but which together form a baseline for strategy building:

  1. Look at historical data to identify pairs of assets (or asset classes) with consistently low correlations to each other. While correlations between assets do change over time, they tend to show some persistence.
  2. Look at historical data to identify assets that have demonstrated consistent growth over time.

A "Foundation Portfolio" for Generating Alpha
One very simple and easy to implement portfolio has been an alpha-generating monster in recent years, and it consists of just two asset classes:

  1. U.S. stocks
  2. Oil futures

This pair of assets has had a low correlation over any historical period. For example, as of December 31, 2007, the correlation between the S&P 500 Index and oil futures was
-0.21 on a five-year look-back basis. A negative correlation indicates that stocks and oil futures are more likely to move in opposite directions during any given month than in the same direction.

In addition to beta, standard deviation is another common measure of volatility. The table and charts below compares the returns and volatilities from 2002 through 2007 (five years) in three hypothetical portfolios: 100% U.S. stocks, 100% oil futures and 50% U.S. stocks and 50% oil futures (unrebalanced).

Measure of Volatility 100% stocks 100% oil futures 50-50*
Average Annual Return 12.8% 25.2% 19%
Monthly Standard Deviation 2.5% 8.3% 4.1%
Sources: Standard & Poor\'s and CRB Commodities.
*50-50 portfolio results shown are unrebalanced.
Figure 1
Source: Standard & Poor\'s and CRB Commodities
Figure 2
Source: Standard & Poor\'s and CRB Commodities

The low correlation between these classes would have produced a better risk-adjusted return profile in the 50-50 mix than in either asset class separately. Rebalancing the 50-50 portfolio periodically would have increased its alpha compared to the un-rebalanced portfolio.

Problems With Hindsight and Complexity
For constructing an alpha-seeking IRA portfolio, the simple two-class portfolio described above poses three problems.

  1. There is no guarantee that future performance will mirror the past.
  2. Two asset classes do not provide adequate portfolio diversification for most investors.
  3. Most individual investors don't know how to participate in asset classes like oil futures easily and economically.

Fortunately, the third issue is the simplest to address. Exchange-traded funds (ETFs) have increased access to a variety of low-correlating asset classes that can be added at fairly low cost to a self-directed brokerage IRA. For example, two ETFs that participate in oil futures are the U.S. Oil Fund (AMEX:USO) and PowerShares DB Oil (AMEX:DBO).

A solution to the first two problems is to combine several different ETFs in an IRA portfolio, each representing an asset class that has historically produced low correlations with U.S. stocks. Below are possible candidates along with their five-year correlations and corresponding ETFs.

Asset Class 5-Year Correlation with S&P 500 Index ETFs
Diversified Commodities -0.03 -iShares GSCI Commodity-Indexed Trust (GSC)
-PowerShares DB Commodity Index Tracing Fund (DBC)
Gold 0.01 -StreetTracks Gold Shares (GLD)
-iShares Comex Gold Trust (IAU)
Japanese Equities 0.35 -iShares MSCI Japan (EWJ)
-iShares S&P/Topix 150 Index (ITF)
REITs 0.41 -DJ Wilshire REIT ETF (RWR)
-Dow Jones U.S. Real Estate Index (IYR)
Source: FactSet as of 2007

How to Increase the Alpha of Your Favorite Mutual Funds
Many investors have developed long-term loyalties to mutual funds that they believe can outperform market averages across bull and bear environments. If you are among them, here is a technique you can use to potentially increase the alpha of your favorite fund.

  1. Maintain the mutual funds that you think have the best chance of beating their benchmarks over time. Sell other funds.
  2. Take the sales proceeds from the funds you sell and participate in a unique series of "short index ETFs" developed by ProShares.

This long/short strategy is designed to amplify any risk-adjusted excess return produced by a successful fund manager by squeezing beta out of that fund's performance. For example, suppose you own $25,000 of a fund with a proven manager, who you believe can beat the S&P 500 Index. This fund has a beta of about 1, the market average. By investing another $25,000 in ProShares Short S&P 500 (SH), you would theoretically reduce the beta of the combined position to about zero. The combined position would profit to the extent that the manager beats the S&P benchmark on a risk-adjusted basis, and this profit could be generated in both up and down markets. (SH aims to produce a nearly perfectly negative correlation with the S&P 500 Index = a beta of about -1.0.)

This technique mirrors the techniques that many "market-neutral" or "long/short" hedge funds employ, and it does so with lower costs, more transparency and lower minimum investments.

In summary, generating alpha is not as complex or elusive as some investment gurus would have you believe - and it can be pursued in a brokerage IRA easily and economically by combining high-performance, low-correlating asset classes, implementing those classes through ETFs and periodically rebalancing the asset classes. The advice of a financial professional can be valuable in evaluating and implementing such a strategy.

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