2010 The α – β Spectrum β α The Whole Market An Individual Stock

Using an alpha-discovery strategy to screen the market 2010 The α – β Spectrum “Smart Beta” β α Style β The Whole Market Value, Growth An Individual Stock Using an alpha-discovery strategy to screen the market

Using a “standard” alpha factor similarity to screen the market 2010 The α – β Spectrum β α Style β Sector β The Whole Market Value, Growth An Individual Stock e.g., banking, healthcare Using a “standard” alpha factor similarity to screen the market

alpha factor similarity 2010 The α – β Spectrum β α Loosely Screened β Tightly Screened β Targeted β The Whole Market Value, Growth An Individual Stock e.g., banking, healthcare e.g., brand value ranking Using a non-standard alpha factor similarity to screen the market

The α – β Spectrum 2010 β α An Asset Class Individual Assets Loosely Screened β Tightly Screened β Targeted β α An Asset Class Individual Assets

Investment Grade Bonds 2010 The α – β Spectrum β α Loosely Screened β Tightly Screened β Targeted β US Equities β α Loosely Screened β Tightly Screened β Targeted β Treasurys β α Loosely Screened β Tightly Screened β Targeted β Investment Grade Bonds β α Loosely Screened β Tightly Screened β Targeted β Hi-Yield Bonds

The α – β Spectrum 2010 U.S Japan Euro-Zone China etc. β α Loosely Screened β Tightly Screened β Targeted β US Equities Treasurys Investment Grade Bonds Hi-Yield Bonds U.S β α Loosely Screened β Tightly Screened β Targeted β Equities Govt Bonds Investment Grade Bonds Hi-Yield Bonds β α Loosely Screened β Tightly Screened β Targeted β Equities Govt Bonds Investment Grade Bonds Hi-Yield Bonds β α Loosely Screened β Tightly Screened β Targeted β Equities Govt Bonds Investment Grade Bonds Hi-Yield Bonds β α Loosely Screened β Tightly Screened β Targeted β Equities Govt Bonds Investment Grade Bonds Hi-Yield Bonds β α Loosely Screened β Tightly Screened β Targeted β Equities Govt Bonds Investment Grade Bonds Hi-Yield Bonds Japan β α Loosely Screened β Tightly Screened β Targeted β Equities Govt Bonds Investment Grade Bonds Hi-Yield Bonds Euro-Zone China etc.

“α” Selecting Beta 2010 U.S Japan Euro-Zone China A Selection Problem β α Loosely Screened β Tightly Screened β Targeted β US Equities Treasurys Investment Grade Bonds Hi-Yield Bonds U.S β α Loosely Screened β Tightly Screened β Targeted β Equities Govt Bonds Investment Grade Bonds Hi-Yield Bonds β α Loosely Screened β Tightly Screened β Targeted β Equities Govt Bonds Investment Grade Bonds Hi-Yield Bonds β α Loosely Screened β Tightly Screened β Targeted β Equities Govt Bonds Investment Grade Bonds Hi-Yield Bonds β α Loosely Screened β Tightly Screened β Targeted β Equities Govt Bonds Investment Grade Bonds Hi-Yield Bonds β α Loosely Screened β Tightly Screened β Targeted β Equities Govt Bonds Investment Grade Bonds Hi-Yield Bonds Japan β Loosely Screened β Tightly Screened β Targeted β α Equities Euro-Zone β Loosely Screened β German Banking Debt Screened β Targeted β α Govt Bonds China β Loosely Screened β Tightly Screened β Targeted β α Investment Grade Bonds A Selection Problem β Loosely Screened β Tightly Screened β Targeted β α Hi-Yield Bonds So, what do you really have again?

2010 Asset Allocation Beta Strategies

The Asset Allocation Gameboard 2010 The Asset Allocation Gameboard Passive Maximum β More β Less β Maximum α US equities Active Bogle Lynch Indexes, ETFs Picking winners

The Asset Allocation Gameboard 2010 The Asset Allocation Gameboard Maximum β Maximum α US equities European Equities Emerging Markets Equities

The Asset Allocation Gameboard 2010 Two Selections The Asset Allocation Gameboard Active/Passive Strategy Choice Maximum β Maximum α Equities Govt Bonds Corporate Bonds Commodities Cash Private Equity Asset Classes

Defining the asset classes 2010 Defining the asset classes Asset classes defined by “broad sweeping differences in fundamental character” debt vs equity domestic vs foreign inflation-sensitive vs deflation-sensitive private vs public liquid vs illiquid

Defining the asset classes 2010 Defining the asset classes Assets in an Asset Class should all respond the same way to key economic variables, like inflation

Weighting the asset classes 2010 Weighting the asset classes “Most portfolios work well with around half a dozen asset classes” At least 5% of the portfolio per asset class No more than about 30% per asset class

Portfolio Construction 2010 Portfolio Construction Choice of Bias (among asset classes)

The Asset Allocation Gameboard Maximum β Maximum α Equities Govt Bonds Corporate Bonds Commodities Cash Private Equity 1/6 How do you spread your “bets” across the various asset classes? 1/6 1/6 1/6 Any imbalanced spread represents a “Bias” 1/6 1/6

Swensen argues strongly for an Equity Bias 2010 Asset Class Selection Positive Bias: Equity Bias Negative Bias: Avoidance of “Bad Asset Classes" Swensen argues strongly for an Equity Bias

Reasons for Equity Bias 2010 Reasons for Equity Bias Based on Historical Performance Market Efficiency

The Equity Bias: Historical Performance Asset Class Multiple 1925-2005 Inflation 11 Treasury Bills 18 Treasury Bonds 71 Corporate Bonds 100 Large-cap Stocks 2,658 Small-cap Stocks 13,706

Market Efficiency Best Hard Best Hard Poor Best Best Equities Maximum β Maximum α Equities Govt Bonds Corporate Bonds Commodities Cash Private Equity Best Hard Best Hard Poor Best Best

Misalignment of Investors’ Interests with Managers’ Interests 2010 Bias Based on Historical Performance Market Efficiency “Agency” Problems Misalignment of Investors’ Interests with Managers’ Interests

Corporate Bonds are always Bad Efficiency Maximum β Maximum α Equities Govt Bonds Corporate Bonds Commodities Cash Private Equity Best Hard Best Corporate Bonds are always Bad Best Best

Portfolio Construction 2010 Portfolio Construction Choice of Bias (among asset classes) Diversification – good anti-correlation characteristics vs Equity Diversification Objective (correlations) Market Regime Assumption

Baseline Equities Maximum β Maximum α Cash Govt Bonds Corporate Bonds Commodities Cash Private Equity

Inflation > 5% per year Maximum β Maximum α Equities Govt Bonds Corporate Bonds Commodities Cash Private Equity

How should the portfolio be repositioned? Market Regimes Inflation Deflation Fed Unwinding Volatility Storms How should the portfolio be repositioned?