Alpha and Beta

Question 1

What is Beta, what is Alpha?

Answer 1

Beta is a measure of the systematic risk and

Alpha is a measure of investment return in excess of the risk-adjusted Benchmark.

Question 2

What is ex ante alpha?

Answer 2

The ANTICIPATED incremental return on an asset, after adjusting for time value of money and systematic risk effects. This is attributable to the skill of the investor.

Question 3

What is ex post alpha?

Answer 3

Also called idiosyncratic return is REALIZED INCREMENTAL return after adjusting for time value of money and systematic risk effects..

This may be attributable to skill, luck or a combination of both.

Question 4

What are the 2 methods of inferring ex ante alpha from ex post alpha?

Answer 4

DE

1. Due diligence analysis: Manager’s investment procedures and style are comprehensively investigated.
2. The empirical analysis method: Use the statistical properties of the ex post alpha to predict ex ante alpha

Question 5

What is the PRIMARY GOAL of return attribution?

Answer 5

The process of ascribing returns to different components of the asset’s perfromance.

Question 6

What is meant by non stationarity of Beta and why is it important?

Answer 6

it means the tendency of Beta to shift over time. This makes it difficult to disentangle alpha and Beta.

Question 7

Give examples of Beta non stationarity and explain each

Answer 7

• Beta creep,
• Beta expansion and
• Market timing

Gradual increase in Beta over time;

Increase in Beta as market conditions change;

Attempts of the fund manager to alter the fund beta in anticipation of changes in market conditions

Question 8

What is the relationship between ex-post alpha and ex ante alpha

Answer 8

ex post alpha (idiosyncratic return) = ex ante alpha + luck (return from idiosyncratic risk)

p = a + l

Question 9

What is meant by abnormal return persistence and

what does a positive correlation suggest?

Answer 9

it refers to the tendency of idiosyncratic performance (ex post alpha) to be positively correlated over time.

It suggests that most superior returns are attributable to skill rather than to luck.

Question 10

What is meant by Return drivers of a portfolio?

What are the classes of Return drivers?

Answer 10

They are the ips :

investments, Investment products and Investment strategies that generate the investment’s risk and return.

Beta drivers and Alpha drivers

Question 11

What is a Beta (return) driver,

what is an Alpha (return) driver?

Answer 11

MRF and ARF

Beta drivers are exposures to market risk factors that compensate investors for bearing nondiversifiable market risk.

• Asset class or geographic location is a Beta driver

Alpha drivers are exposures to active risk factors that enable the investor to make returns unrelated to the benchmark.

• Investment strategy is an alpha driver.

Question 12

What is the Equity Premium Puzzle?

Answer 12

The tendency of ERP (difference between equity return and risk free rate) to exceed its expected value based solely on risk aversion.

• Risk Averse Investor; An investor who, when faced with two investments with a similar expected return (but different risks), will prefer the one with the lower risk.

Question 13

What is meant by passive Beta (return) driver?

Answer 13

Return drivers are exposures. Beta driver is exposure to MRFs. Alpha driver is exposure to ARFs. A return driver from a pure play on Beta is a passive Beta driver. Pure play on Beta refers to passive investing such as buy and hold strategy to replicate a benchmark index.

Question 14

What are the major alpha drivers?

Answer 14

6 of them, PLANSA
a) Long/ short investments

d) Portfolio concentration (assume greater tracking error to an established benchmark)
c) Absolute return investments;
d) Segmented markets (conentrate on what you know);
e) Non linear return distributions (option like payoff);
f) Alternative Beta exposures (risk exposures to currencies, real estate or commodities)

Question 15

What is the difference between Product Innovators and Process drivers

Answer 15

Product innovators are Alpha drivers, for example active management funds such as 130/30 long short funds.

Process drivers are Beta drivers that deliver Beta as cheaply and efficiently as possible;

Question 16

What is meant by Beta non stationarity?

What question does it raise?

Answer 16

Tendency for Beta to shift over time.

Whether the asset’s superior return is attributable to alpha or Beta.

Question 17

What are the 3 primary types of model misspecification, stating the effect of each on return attribution?

Answer 17

M, N, 0

1. misestimated Betas: the return attribution will be misestimated.
2. nonlinear relationships: If the relationship is quadratic or exponential, then the estimate of systematic or idiosyncratic return components of the assets will be biased. AI return often have non linear relationships.
3. Omitted or misidentified factors: :biases associated with ommitted factors.

Question 18

Why are most alternative assets classified as alpha drivers?

Answer 18

Due to their reliance on complex, active management strategies that have low correlations with traditional asset classes.

Question 19

Long/ short investments, Investment Strategy

Answer 19

It is an Alpha driver OR exposures to ARF (active retrun factors),

• Investment strategy of taking long positions in stocks that are expected to rise and take short position in stock that are expected to fall

Question 20

Concentrated portfolio

What do you have to say about tracking error for them?

Answer 20

An alpha driver or investment strategy designed to outperform the market.

• Concentrate more on certain markets, sectors, or firms rather than pursuing high diversification.
• They have high tracking error compared to an established benchmark.

Question 21

Absolute return investments, an Alpha driver

Answer 21

Alpha driver is an investment strategy.

It is an Alpha driver OR exposures to ARF (active retrun factors), Alpha drivers are designed to outperform the market.

• Pursue high returns independent from general market trends rather than relative to a market index.

Question 22

Market Segmentation, an alpha driver

Answer 22

It is an Alpha driver OR exposures to ARF (active retrun factors), Alpha driver are designed to outperform the market.

• Avoid or buld expertise in certain segments of the markets. Commodities, real estate, noninvestment grade debt are examples where Alpha can be found.

Question 23

Investment strategy, Nonlinear return processes

Answer 23

It is an Alpha driver OR exposures to ARF (active retrun factors), Alpha drivers are designed to outperform the market.

• They exhibit options like pay off with a kinked relationship linked to some return factor

Question 24

Alternative/ cheap beta exposure, an Alpha driver

Answer 24

It is an Alpha driver OR exposures to ARF (active retrun factors),

Alpha drivers, there are 6 of them, are designed to outperform the market.

• Gain access to favorably priced (cheap) systematic risk premium Alternative Investments in this category may inlcude risk exposures to currencies, real estate, or commodities.