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Switching Horses Mid-Race: How to know when riding different betas

creates alpha
Alpha doesn't always have to come from security selection - as today's guest contributor points out.

When you think about it, the idea of an investment benchmark is

somewhat philosophical. Although many hedge fund managers profess to
deliver uncorrelated “absolute” returns – not relative returns – a large
portion of them compare their results to equity markets. Why? Not
because they manage to that bogey, but because hedge fund allocations
are often made by diverting capital from equity allocations. In other
words, equities are the most likely alternative. Today’s guest contributor
says that the choice of benchmark can make or break a “horse-switching” manager.

Measuring Performance in Active Allocation amongst Multiple Benchmarks

Special to by: Eric Stanhope Hirschberg, Orion Investment Management (with
programming assistance from Hamaad Shah)

“Process is the one aspect of investing that I can control. Yet all too often I focus on outcomes
rather than process. Yet ironically, the best way of getting good outcomes is to follow a sound
process. The research shows that holding people accountable for outcomes tends to lead to suboptimal
performance, generally because they spend all their time worrying about the things they can’t control. I’d
advise a far better approach to assess people on the criteria of adherence to process.” — James Montier

Benchmarks: What are they good for?

While it’s tempting to say “absolutely nothing”, benchmarks have a meaningful role in the allocation
process. How relevant a benchmark is to the investor really comes down to the context in which the
benchmark is derived.

My personal preference is to view a benchmark as a tool to understand the alternative to an allocation. In

this way the “goodness” of a choice can be measured against the alternative of not choosing, or for that
matter making any alternative choice. This is a local perspective, in so much as one’s choices and risk
tolerances are not uniform to an entire investment population. For that, I need to accept the nearest
correlating passive and investable asset as the benchmark. And while this approach is fine for a strategy that
maintains a significant correlation to a passive investable benchmark, how should I view the myriad of
strategies in which the Manager / Asset Allocator tells us his expertise is to opportunistically invest?

Consider the manager who is actively making choices to allocate or de-allocate between a number of
possible strategies or benchmarks, based on some criterion which he holds as his proprietary domain. I shall
demonstrate a methodology that allows one to break down this Manager / Asset Allocator’s strategy into a
series of choice components, with a corresponding framework for valuing the various choices made over the
investment horizon.
Measurement as a Function of Rational Choice

So let us construct a way to measure this class of active managers.

Firstly, since I cannot know what goes on inside the head of our Manager / Asset Allocator, let us derive a
set of assumptions and move on from there.

Assumption 1: The Manager / Asset Allocator chooses the best risk adjusted return he can get us.

While he could just roll the dice on the riskiest assets, his return is maximized by staying in the game, and as
the risk adjusted return accounts for the risk of ruin and other shades of undesirable outcomes, it maximizes
the chance of success. His success is a function of his ability to forecast his risk adjusted return. His failure to
do this Ill does not warrant our discarding the assumption that he is trying.

Assumption 2: The Manager / Asset Allocator actively chooses between assets as opposed to
assets held mutating from one exposure to another.

There have certainly been times in the history of finance where a Manager / Asset Allocator maintaining a
“static” strategy, experiences a huge style or exposure shift as a result of an exogenous factor he wasn’t
aware he was choosing. A short portfolio of Canadian junior mining assets, overnight became a portfolio of
internet start ups, as bankers realized buying worthless shells and converting them was cheaper than the
opportunity cost of waiting for the public issuance backlog in 2000. I will limit our discussion to the normal
case of active allocation by the Manager / Asset Allocator.

Assumption 3: The Manager / Asset Allocator can choose to invest in the passive benchmark or
actively replicate it.

The Manager / Asset Allocator uses assumption 1 to choose portfolio A’ with respect to A. If he can’t find
anything better than a, he will simply invest in A (provided that he believes the risk adjusted return of A is
greater than that of B). This is often the case with CTA’s, many of whom simply choose the ETF or Futures
contract over some optimized portfolio.

Assumption 4: The Manager / Asset Allocator’s portfolio constituents and their respective weights
are transparent to us.

To calculate the Manager / Asset Allocator’s tracking error (A’-A) I need to know the constituents of the
Manager / Asset Allocator’s portfolio.
Analysis of the Two Benchmark Case

For the purposes of this analysis, I consider:

• A strategy that allocates between 2 available benchmarks (A, B). To be clear, while it is easier to
know which benchmarks should be used a priori, it is not a necessity, as there are effective ways in
which I can discover the benchmarks through data analysis.
• The Manager / Asset Allocator invests in or replicate a benchmark A at some particular time, using
strategy portfolio A‘. I will assume some unknown difference, but A’=A would still work.

At T=0, the Manager / Asset Allocator Chooses To invest in A (and not B) and does so by construction of
replicant A’.

Piece-wise Analysis: Period 1

At T=100 I consider five pieces of information:

1. Corr (A’, A). I want to understand the portfolios active versus passive allocation component. In other
words, was there any value created in the replication process?
2. Ret (A’) – Ret (A). I want to understand the value of active versus passive allocation. What was the
value of replication?
3. Ret (A)-Ret (B) .I want to understand the value of switching.
4. Information Ratio* A’/A= Ret (A’-A)/ Stdev (A’-A). I want a measure of the risk adjusted return of the
active allocation.
5. Information Ratio* A/B = Ret (A-B)/Stdev (A-B). I want a measure of the risk adjusted return of

* The information ratio used is based upon geometric returns and adjusted for leverage effects.At T=100, the
Manager / Asset Allocator Switches from Benchmark A to Benchmark
Piece-wise Analysis: Period 2

At T=200 I again consider five pieces of information:

1. Corr(B’,B)
2. Ret(B’-B)
3. Ret(B-A)
4. Information Ratio B’/B = Ret(B’-B)/Stdev(B’-B)
5. Information Ratio B/A = Ret(B-A)/ Stdev(B-A)

At T=200, the Manager / Asset Allocator Switches from Benchmark B back to Benchmark A

Piece-wise Analysis: Period 3

At T=300 I again consider five pieces of information:

1. Corr(A’,A)
2. Ret(A’-A)
3. Ret(A-B)
4. Information Ratio A’/A = Ret(A’-A)/Stdev(A’-A)
5. Information Ratio A/B = Ret(A-B)/ Stdev(A-B)

Adding it all up

Taking the prior example, a tactical allocator made 3 allocation decisions in a 300 day period. The total
return is as follows:

tRet’ = Ret (A’)0 to 100 + Ret(B’)100 to 200 + Ret(A’)200 to 300

At this point I should be asking three questions:

• First, did the Manager / Asset Allocator add any value over the piecewise benchmarks using
replicants, i.e. was tRet’ > tRet ? What was the weighted sum of the information ratios?
• Secondly, did the Manager / Asset Allocator add any value over a simulated tactical switching model
with the same benchmark universe and an equal number of randomly timed switches?
• Thirdly, how did the Manager / Asset Allocator’s allocation compare to all convex combinations of
the two benchmark assets held passively over the same period?
Example: Three Allocation Decisions

To illustrate an example, I use SP500 index and US Treasury Index Data for a two and one half year interval

I create a fictitious Manager / Asset Allocator who makes three allocation decisions over this interval. For
simplicities sake, I have chosen a Manager / Asset Allocator who is limited to investment in the benchmarks
themselves (A’ equal to A). The identical analysis can be performed on the portfolios where, the Manager /
Asset Allocator chooses as a replacement for the simple benchmark (A’ not equal to A).

• No transaction costs are considered as there are a total of six transactions (in liquid securities) over
the entire period.
• I do not consider corr(A’,A) as it remains constant 1 in this example due to Manager / Asset
Allocator investment limitations.
• No leverage is used in this example. That said, one can easily adjust for the effects of leverage by
normalizing using the beta coefficients (M) of A’= MA +b and B’=MB + c for each interval chosen.

In practice, this normalization should always be undertaken when considering quality of returns.
The Return Distribution for the Three Allocation Simulation

By plotting the Manager / Asset Allocator’s return as a function of switching versus the boot-strapped
distribution of outcomes, I can ascertain a probability of skill for the Manager / Asset Allocator’s ability to
time benchmark exposure. By comparing the replicant returns as a function of deviation, I can formulate a
statement about the Manager / Asset Allocator’s ability to create additional value given a benchmark
exposure. The following chart shows the outcome from randomly sampling 2000 sets of three switches ABA
or BAB from the previously mentioned data. The red dot marks our Manager / Asset Allocator’s return in this

The Information Coefficient Distribution for the Three Allocation Simulation

As the Manager / Asset Allocator is claiming his skill comes from his ability to time switches, our analysis
now allows us to make an objective assessment of his claim. Our Manager / Asset Allocator’s resultant IC is
shown as a red point on the chart below. In this case, it is clear that he should be compensated beyond the
cost of active replication as replacing him with a random switching algorithm would likely produce an
inferior result. Had the Manager / Asset Allocator’s IC been less than the mean of the distribution, the
expected value from employing a switching algorith would have been greater, and it would be economically
beneficial to replace him.

Reduce Manager
or Replicate
Mapping the Three Allocation Simulation Over All Convex Combinations of the Two Benchmark Buy and

Now let us compare the Manager / Asset Allocator’s total return and deviation with both simulated switches
and all possible passive benchmark mixes. These mixes take the form Total Return (cA+dB) and standard
deviation of returns (cA+dB) where c=0 to 1 and d=1-c. The lower left endpoint of the line represents a 100%
allocation to the Bond Index while the upper right endpoint represents a 100% allocation to the equity index.

Note that our Manager / Asset Allocator has performed quite Ill. He beats a significant majority of our
simulated switches, and his active return could not be passively replicated without a significant increase in
risk. In this case the Manager / Asset Allocator’s compensation for actively switching is Ill deserved.

I have endeavoured to formulate a framework for evaluating a Manager / Asset Allocator who actively
moves between two investments. A simple example of equities and bonds was illustrated for an initial
selection plus two additional switches. I could have as easily used two styles (growth and value, or large cap
and small cap) as benchmark assets. Under this regime, the Manager / Asset Allocator can switch between
benchmarks tactically, opportunistically or even unknowingly, it really does not affect our ability to measure
the Manager / Asset Allocator’s utility in doing what he/she does.

The methodology presented in this paper forms the basis for evaluating a Manager / Asset Allocator that
moves, in part or in whole, between multiple benchmarks. My work on this expanded problem will
presented at a later date.

I note that there is a school of thought that believes that one way to measure a Manager / Asset Allocator’s
addition of active value is to take his initial portfolio and hold it passively as the benchmark “inertia
benchmark”. This notion, while creative, is flawed in a number of respects.

Firstly, as open funds can receive allocations from investors somewhat continuously (depending on
addition/redemption terms); the benchmark could vary dramatically by date.

Secondly, just because an investor starts off in a particular portfolio by means of subscription, that does not
imply that the portfolio would have been purchased by the manager had he been required to hold it for
some fixed period. Based on my experience transacting institutional portfolio rebalances for a number of
years, I would say that individual component durations are far from uniform.

Lastly, one utility of a benchmark is that it allows the investor access to an alternative allocation. If the
investor has to rely upon the Manager to present the initial portfolio, it is unlikely that the investor would be
able to construct the aforementioned portfolio without the assistance of the Manager, thereby invalidating
the concept of the benchmark as a means of alternative allocation.

Authors Note: If you would like to learn more about implementing my risk and performance measurements
for your organization, feel free to contact me via or contact me via LinkedIn. Any
comments or criticisms are most appreciated.