If 2009 was about beta capture in investing, this year should be about capturing alpha.
After being thrown for a dramatic loss in 2008 and then riding a wild 2009, it feels a bit like we have been battling a bucking bronco for the last two years. However, the stock, fixed income and real estate markets seem to have settled down, and we can face 2010 by climbing back on the horse that threw us and set out on a more confident course.
More succinctly, now is the time to make intelligent portfolio decisions about capturing alpha.
In 2008, risky asset classes were punished. As a result, at the beginning of 2009, values were depressed across every asset class with any risk attached to it. In 2008, Treasury bonds and short-duration securities, e.g., money market funds, were the only asset classes to enjoy a positive return.
This situation changed dramatically in 2009 as the typically riskier asset classes surged back into positive territory. For example, the MSCI Emerging Markets index earned almost 75% for 2009, while the Barclays Capital U.S. High Yield index returned 58% and the Credit Suisse Leveraged Loan index, 44%. In addition, large-cap stocks represented by the Standard & Poor's 500 enjoyed a return of 26% and the Dow Jones U.S. Select Real Estate Securities index returned about 30%. Conversely, the Barclays Capital U.S. Treasury Bond index had a return of more than -10% in 2009 as long-term interest rates rose dramatically during the year.
What these data points indicate is that 2009 was mostly about “beta capture.”
At the beginning of last year, all asset classes were so severely depressed that a widely diversified portfolio across these asset classes would have enjoyed a bountiful return just by tracking the systematic risk associated with each asset class. In other words, the capture of systematic risk premiums offered a great opportunity last year to reap strong returns simply by riding the wave of asset class appreciation. The deep discounts associated with risky asset classes last year were expected to rebound to more normal levels over time.
What caught most of us off-guard, though, was how quickly these risky asset classes rebounded from their discounted levels. For example, the 75% return in 2009 associated with the MSCI Emerging Markets index was the largest one-year gain in the history of that index, dating to 1987. The gains across the other risky asset classes were just as dramatic. Active management still added value in 2009, but it was outweighed by the large increase in systematic or beta returns. However, we cannot expect to enjoy bountiful returns every year just by riding the wave of asset appreciation.
As the financial markets begin to swing back into a more normal economic equilibrium, 2010 is a year when “alpha capture” becomes more important. When asset classes become more fairly valued, one of the best ways to add value to a portfolio is through active portfolio management and smart security selection.
Alpha capture is a skill, not an art. Indeed, the use of information ratios is a way to measure, on a risk-adjusted basis, the level of skill associated with an active manager.
So where are the best alpha-capture opportunities? First, for those investors who are willing to dip only a toe back into the active management waters, traditional stock and bond products offer the potential for good alpha capture. Even though the financial markets are acting in a more normal risk and return trade-off, there is still an opportunity for active managers to find undervalued stocks and bonds for their portfolios. Indeed, we are still making our way out of a very deep recession and a horrific liquidity and credit crisis. The return to risky asset classes is again positive, but we are not in such a precise equilibrium that active portfolio management cannot add value.
In fact, I hold the opinion that the financial markets are never in a perfect equilibrium. Even as the cost of information gathering with respect to security prices declines, the value of that information is determined by the intelligent filter of the active manager. Acquiring information is one thing, analyzing it into an intelligent security selection process is another.
Furthermore, the financial markets are all too often ruled by human biases such as herding, overconfidence, market segmentation and overreaction to new information. These biases create inefficient security pricing and provide opportunities for smart managers.
For those investors willing to make larger active bets, alternative assets such as commodities, hedge funds, private equity, and real estate offer potentially large opportunities to capture active returns. There will always be some element of systematic, or beta, return associated with the returns produced by an active manager. But now, the balance has shifted in favor of the active manager. It's time to get back into the saddle of active portfolio management.
Mark Anson is managing partner and chief investment officer of Oak Hill Investment Management Group, Menlo Park, Calif. Until early April, he was president and executive director of investment services of Nuveen Investments Inc., Chicago. The views expressed in the commentary are his own and not necessarily those of the firms.