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Active Alpha: A Portfolio Approach to Selecting and Managing Alternative Investments

ISBN: 978-0-471-79132-4
384 pages
August 2007
Active Alpha: A Portfolio Approach to Selecting and Managing Alternative Investments (0471791326) cover image

Description

Praise for Active Alpha

"Active alpha is the quest for every sophisticated investor. This book covers all of the key alpha sources currently mined by active managers, reduces the complexity of the subject, and helps the investor get started in the right direction."
-Mark Anson, Chief Executive Officer, Hermes Pensions Management Ltd.

"Long-held traditional methods for investing large portfolios are giving way to new processes that are designed to improve productivity and diversification. These changes find their locus in the sometimes overly mysterious world of absolute return strategies. In this book, Alan Dorsey demystifies that new world and provides a guiding pathway into the future of professional portfolio management. This is an important read for any investor who plans to succeed going forward."
-Britt Harris, Chief Investment Officer, Teacher Retirement System of Texas

"With great lucidity, Alan Dorsey's book, Active Alpha, fills an important void by identifying the relevant institutional features of this complex subject and by providing a unifying analytic framework for understanding and constructing portfolios of alternative assets. For anyone investing in the alternative class, from the new student to the experienced practitioner, Active Alpha is a necessary read. I am recommending it to everyone I know with such an interest, and it is destined to become a much thumbed reference on my shelf."
-Steve Ross, Franco Modigliani Professor of Financial Economics, Sloan School, MIT
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Table of Contents

Preface xi

Acknowledgments xv

About the Author xvi

PART ONE Alternative Investments and Investors

CHAPTER 1 Introduction 3

Integration of Alternative Investments and Traditional Asset Classes through Factor Analysis 3

Approaches to Portfolio Construction 4

The Identification of Alpha and Beta in New Investment Strategies 5

What the Future Holds 8

Summary 8

CHAPTER 2 Investors in Alternative Investments and the Necessary Ingredients for a Successful Program 11

Types of Investors and Their Approaches to Alternative Investments 12

The Necessary Ingredients for a Successful Alternative Investment Program 18

Support from Investment Management Firms and Consultants 33

Investors Deciding to Minimize the Use of Alternative Investments 36

Summary 42

CHAPTER 3 Hedge Funds 43

Performance and Diversification Attributes 43

Market Segmentation 47

Hedge Fund Strategies 47

The Construction of a Segregated Portfolio of Hedge Funds 69

Summary 74

CHAPTER 4 Private Equity 77

Performance and Diversification Attributes 77

Dispersion of Returns 83

Private Equity Strategies 85

The Construction of a Segregated Portfolio of Private Equity 95

Summary 97

CHAPTER 5 Real Estate 99

What Is the Attraction? 99

Real Estate Strategies 104

The Construction of a Segregated Portfolio of Real Estate 114

Summary 123

CHAPTER 6 Currency, Commodities, Timber, and Oil and Gas 125

The Qualitative Determinants of Returns 125

The Attraction of Currency 127

The Attraction of Commodities 130

Currency and Commodity Strategies 132

The Attraction of Timber 136

Timber Strategies 139

The Attraction of Oil and Gas 140

Oil and Gas Strategies 142

The Construction of a Segregated Portfolio of Currencies, Commodities, Timber, and Oil and Gas 144

Summary 147

PART TWO Alternative Investments in Traditional Portfolios

CHAPTER 7 The Migration of Hedge Funds into the Private Equity Realm 151

Are Hedge Funds Gaining Market Share from Private Equity? 152

How Well Suited Are Hedge Funds to Private Equity Investments? 157

The Power of Compounding: A Comparative Advantage for Private Equity 159

The Fee Differential between Hedge Funds and Private Equity 160

Alternative Investment Fee and Term Components 164

Summary 176

CHAPTER 8 Cash Flow Forecasting and Its Implications for Rebalancing 177

Alternative Investment Cash Flow 177

Asset Allocation: Achieving Policy Targets and Rebalancing 195

Cash Flow Forecasting Tools 199

Portfolio Rebalancing Tools 202

Summary 205

CHAPTER 9 Leverage and Portable Alpha 207

Leverage 208

Portable Alpha 213

What Is Portable Alpha? 213

The Benefits and Issues with Portable Alpha 218

Reevaluating the Premise for Portable Alpha 219

The Use of Hedge Funds in Portable Alpha 221

Alternative Thinking about Alpha 227

Summary 231

CHAPTER 10 Factor Analysis: The Rationale 233

Marketplace Changes that Warrant Factor Analysis 234

The Asset-Class Concept 236

Alternative Investments and Factor Analysis 241

Problems with Selecting Vehicles for Alternative Investment Portfolio Construction 243

Quantitative Building Blocks 244

Risk Budgeting Using Factors 249

Beyond Traditional Asset-Class Risk Budgeting 250

Qualitative Independent Variables 253

Illiquidity Factor 255

Summary 271

CHAPTER 11 Factor Analysis: The Findings and Discovering Active Alpha 273

Time Series Delineation and Issues 273

Mean-Variance Optimization 277

Problems Using Mean-Variance Optimization with Alternative Investments 294

Regression Analysis with Alternative Investment Factors 294

Regression Analysis Results and Observations 296

Problems with Conducting Regression Analysis on Alternative Investments 302

Factor Optimization 304

Active Alpha versus Passive Alpha 309

Problems with Factor Optimization 311

Synthetic Portfolios of Alternative Investments 312

Factor Measurement and Risk Monitoring 313

Summary 314

Appendix: Regression Methodology 316

Notes 347

Glossary 351

References 363

Index 369

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Author Information

ALAN H. DORSEY is a Managing Director and Alternative Investment Strategist at Lehman Brothers. He is cohead of Portfolio Advisory for the Private Investment Management group that serves Lehman's high-net-worth clients and head of Portfolio Strategy for multi-asset class institutional portfolios with a focus on alternative investments. Prior to joining Lehman Brothers, Dorsey was managing director and director of non-traditional investments and research at RogersCasey, a leading consultant to pension funds and other institutional investors. He holds a BA in economics from Wesleyan University and is a Chartered Financial Analyst. Since 1997, Dorsey has served as a member of the investment committee for Wesleyan University, where he is a past trustee. He became a trustee for the Lehman Brothers defined benefit pension plan in 2007.
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