The post “What to Do When Alpha Becomes Beta” first appeared on Alpha Architect Blog.
Dynamic Strategy Migration and the Evolution of Risk Premia
- David E. Kuenzi
- Journal of Portfolio Management
- A version of this paper can be found here
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Why does it matter?
I thought this was an interesting take on the mechanics behind the “commoditization” of quantitative strategies. Although, it does not tell us which risk model is theoretically correct, nor does it answer the question of: “is it alpha or is it beta?”, it does provide an explanation of how the migration from alpha to beta might occur. Very helpful. As for application, the author suggests that investors and managers may benefit by providing such a context (“big picture”) when considering their current strategies. Where are their current strategies positioned with respect to the stylized stages? How does that position impact the development of new strategies and management of strategy timing? How does this framework interact with the recent literature associated with issues of factor crowding? Good questions to consider for all asset allocators.
The most important chart from the paper
The author creates a conceptual model for risk premia strategies, focusing on the notion of a continuum running from pure alpha to pure beta and where on this continuum a given manager or investor would like to engage with the markets. He suggests that a risk premium that is nearly completely unknown is really a source of alpha, which then becomes more risk premia–like as it gains market acceptance. As such, there is an inexorable pull toward commoditization for any known and profitable investment strategy. A key question for both risk premia asset managers and investors is how to operate in this dynamic environment. The investment manager might consider how to adapt and perhaps research and migrate to new, less-commoditized strategies over time. The investor must decide what mix of managers along this continuum to select. Finally, the author provides empirical evidence that naïve versions of some of the most known risk premia strategies have indeed shown signs of commoditization in the post-crisis period as compared to the pre-crisis period. Broadly, he suggests that in the face of investment strategy degradation, investors and managers must consider adaptive approaches to the markets and to upgrading their strategies or strategy allocations.
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