Equity Portfolio Construction: Filling the Gap Between Alpha and Beta

Separating equity alpha and beta is a good first step—but could investors be doing more in the space left between them?

Investors are increasingly implementing global equity investments by splitting allocations between concentrated, high-active share strategies on one side and passive products on the other. We view this barbell-like, alpha-beta separation approach as sensible in terms of optimizing between cost and active risk.

However, abandoning what we view as the flawed middle ground of over-diversified, low-tracking error active management (or “closet-indexing”) need not mean neglecting what we view as a proven, efficient middle ground of systematic premia paid to value, carry, quality, momentum and insurance risks. Or, to put it another way, an investor that accepts the systematic exposures of passive management can consider other, similarly cost-effective systematic exposures.

In this paper, we show how adding risks, in the form of diversified risk premia and put-option-writing strategies, can bring additional diversification, alpha and risk-adjusted return to an activeplus-passive global equity allocation.

Executive Summary

• Separating alpha and beta and moving away from over-diversified “closet indexing” strategies can make investment portfolios more efficient.
• But on its own, a barbell-like alpha-beta separation portfolio assumes that an investor is only interested in the systematic biases and exposures that come with market capitalization-weighted allocations—chiefly large-cap growth and momentum.
• We believe that a larger middle ground of useful systematic factors or risk premia exists to be extracted between passive and highly active allocations: while these strategies can look like “closet indexing,” they use diversification systematically to isolate specific risks.
• We focus on five premia from global developed and emerging markets equities that are available as index products: value, size, quality and momentum, as well as the insurance premia that can be extracted through put-option-writing strategies.
• We show the impact of adding these five premia to standard developed world and emerging markets alpha-beta separation portfolios, between 2006 and 2019.
• Specifically, we show that “completing” equity factor and risk premia exposures can deliver additional diversification, alpha and risk-adjusted return.

Completing the Alpha-beta Separation Portfolio With Multi-factor Equity and Put-option Writing

Source: Neuberger Berman. For illustrative purposes only.