Portable Alpha Theory and Practice: What Investors Really Need to Know

338 Pages·2008·11.355 MB·English

by  Sabrina Callin, Bill Gross

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Portable Alpha
Theory and
Practice
What Investors Really
Need to Know
SABRINA CALLIN, CFA
John Wiley & Sons, Inc.
i
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viii
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Portable Alpha
Theory and
Practice
What Investors Really
Need to Know
SABRINA CALLIN, CFA
John Wiley & Sons, Inc.
i
fm JWBK108-Callin February8,2008 0:28 CharCount=0
Copyright(cid:1)C 2008byPacificInvestmentManagementCompany,LLC.Allrightsreserved.
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LibraryofCongressCataloging-in-PublicationData
Callin,Sabrina.
Portablealphatheoryandpractice:whatinvestorsreallyneedtoknow/SabrinaCallin.
p.cm.–(Wileyfinanceseries)
Includesbibliographicalreferencesandindex.
ISBN978-0-470-11808-5(cloth)
1.Portfoliomanagement. 2.Investments. I.Title.
HG4529.5.C34 2008
332.63(cid:2)2042–dc22 2007045714
PrintedintheUnitedStatesofAmerica.
10 9 8 7 6 5 4 3 2 1
ii
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Contents
ForewordbyWilliamGross ix
Preface xi
Acknowledgments xv
CHAPTER1
OverviewofBookandKeyConcepts 1
SabrinaCallin
BorrowingtoAchieveHigherReturns 3
Leverage—TheGood,theBad,andtheUgly 4
TheConfusionSurroundingAlphaandBeta 7
PortableAlphaDefinitionsandTrends 9
BacktotheBasics:Investments101 10
AssetAllocationandPortableAlpha 10
Alpha,Beta,andAlpha-BetaSeparation 11
GlobalSourcesofPortableAlpha,AssociatedRisks,
andActiveManagement 11
Derivatives-BasedBetaManagement 12
PortableAlphaImplementation 13
TheRealHolyGrail:RiskMeasurementandManagement 13
Liability-DrivenInvesting 14
PortableAlphaTheoryandPractice:WrappingItUp 14
CHAPTER2
PortableAlphaDefinitionsandTrends 15
SabrinaCallin
TheValueofandComponentstoPortingAlpha 16
TheDerivatives-BasedMarketExposure(Beta) 20
TheAlphaStrategy 21
CommonMisperceptions 22
TheEvolutionofPortableAlpha 24
ANewParadigm? 28
iii
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iv CONTENTS
TheImportanceofReturn—AndRisk 30
Conclusion 38
CHAPTER3
BacktotheBasics:Investments101 39
AlfredMurataandSabrinaCallin
TheOptimalInvestmentPortfolio 40
UtilityFunctionsandRiskAversion 41
PortfolioSelectionandtheEfficientFrontier 42
TheCapitalMarketLine 45
CAPMandFactorModels 47
TheBenefitsofDiversification 48
RiskPremiums 49
TheoryversusReality 51
Conclusion 57
Appendix3.1OptionPricing 58
Appendix3.2MergerArbitrageExample 61
CHAPTER4
AssetAllocationandPortableAlpha 65
RobArnottandBrentHarris
AWorldofLowerReturns 66
TheClassicModelforPortfolioConstruction 69
ChallengeswiththeClassicModel 70
PortableAlpha,LevelOne 71
PortableAlpha,LevelTwo 73
PitfallsofPorting 75
RiskBudgeting:AnImpreciseScience 77
SustainableSpendinginaLower-ReturnWorld 79
TheConstituentPartsofaSpendingPolicy 80
TheRiskPremiumandtheBuildingBlocksofReturn 81
TheRoleofAlphainSettingExpectations 81
Contributions 82
TheImplicationsofaSlenderRiskPremium 83
StocksfortheLongRun? 84
DividendsandaSlenderRiskPremium 86
BenchmarkingatthePortfolioLevel 87
InSearchofaBetterRiskMeasure 88
WhatIsSuccess? 90
Conclusion 93
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Contents v
CHAPTER5
Alpha,Beta,andAlpha-BetaSeparation 95
SabrinaCallin
BetaandAlphaDefined 96
CAPM,Alpha,andBeta 97
AlphaandBetainaPortfolioEvaluationContext 98
TheRelevanceofAlphaversusExcessReturn 100
KeyChallengesofAlpha-BetaSeparationandEstimation 101
AlphaIsNotAlphawithoutBeta 104
PortingCanBeCostly 105
IstheAlphaActuallyAlpha? 109
Beta+Beta(+Beta...)+Alpha? 117
Conclusion 126
Appendix5.1TheTroublewithAlphabyJamilBaz 127
CHAPTER6
GlobalSourcesofPortableAlpha,AssociatedRisks,and
ActiveManagement 135
SabrinaCallin,AlfredMurata,DonSuskind,SteveJones,
RichardClarida,andLisaKim
OverviewbySabrinaCallinandAlfredMurata 136
TheEquityMarketsbyDonSuskind 141
TheFixed-IncomeMarketsbySteveJones 146
GlobalDiversificationandCurrencybyRichardClarida 154
HedgeFundsStrategiesbyLisaKim 165
Conclusion 179
CHAPTER7
Derivatives-BasedBetaManagement 183
JimKellerandMihirWorah
SecuritiesLendingasaFormofLow-RiskPortableAlpha 183
Futures 185
Swaps 189
BetaManagement:BasisRisk 192
ExamplesofProactiveBetaManagement 194
BetaManagement:OperationalRisk 198
Recommendations 199
Conclusion 201
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vi CONTENTS
CHAPTER8
PortableAlphaImplementation 203
SabrinaCallin
TheAlphaStrategy 204
TheDerivatives-BasedMarketExposure(Beta) 205
LiquidityforMarginorCollateralCalls 205
ConsolidatedRiskManagement,Monitoring,
andReporting 211
IntegratedApproaches 214
SegregatedApproaches 215
SemibundledApproaches 216
ComparingandContrastingDifferentApproaches 218
ImplementationCosts 219
EvaluatingPortableAlphaImplementationApproaches 220
Conclusion 221
Appendix8.1SegregatedPortableAlphaCaseStudyby
BruceBrittain 221
CHAPTER9
TheRealHolyGrail:RiskMeasurementandManagement 225
VineerBhansali
IdentifyingRisks:Alpha,Beta,andLeverage 226
LiquidityandCorrelation 229
TheConsequencesofLeverage 233
StressTesting:MeasuringRiskinPortableAlpha 235
HistoryandTimeHorizons 240
Conclusion 241
CHAPTER10
Liability-DrivenInvesting 243
JimMoore
WhatIsLDI? 244
LessRoomforComplacency 249
ExaminingtheLiabilities 252
Liability-DrivenInvesting 255
CaseStudy:IntoPhaseIII 263
BeyondLDI:IncorporatingFactorsoutsidethePensionPlan 267
Conclusion 269
Appendix10.1BuildingBetterBetasthroughFinancial
Engineering 269
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Contents vii
CHAPTER11
PortableAlphaTheoryandPractice:WrappingItUp 273
SabrinaCallin
AbilitytoBorrowthroughtheDerivativesMarketSets
theStageforPortableAlpha 274
CentralUnderpinningstoModernPortfolioTheory
AreHighlyRelevant 275
AlphaandBeta—It’stheCombinationThatMatters 276
AWideVarietyofAlphaSourcesAreAvailable 278
TheKeyIsIdentification,Measurement,and
DiversificationofRiskFactors 279
It’sImportantNottoLoseSightofthePolicyPortfolio 280
PrudentDerivatives-BasedBetaManagementIsNotFree 281
PortableAlphaImplementationCanBeComplex
andCostly 282
RiskManagementIsaCriticalComponentofSuccess 282
PortableAlphaIsAlsoValuableforInvestorsFocused
onLDI 284
PortableAlphaProvidesToolsforBetterInvestmentResults 285
EPILOGUE
PortableAlpha—TheFinalChapter:Schemes,Dreams,and
FinancialImbalances:“ThereMustBeMoreMoney” 287
ChrisP.Dialynas
RiskAsymmetries:Volatility,Spread,Leverage 290
AbsoluteReturnDynamics 293
TheU.S.CurrentAccountDeficit,War,andHedge
Funds:Briefly 295
PublicPolicyImplications 296
Conclusion 297
Notes 299
Bibliography 303
AbouttheAuthors 306
Index 311