The question is often asked, "What do I need in my portfolio?". The answer is usually long-winded with deep discussions about asset classes, factors, securities, and risk. I think we can make it easier by putting the discussion in a BAG - focus on three things: beta, alpha, and gamma. If you can keep it simple, it is more likely you can get a better portfolio mix.
To BAG performance you need:
- BETA - exposure to the major asset classes. This exposure is where most risk will be in a portfolio. Beta exposure is not immutable. It can be dynamic and adjust to market conditions. Static beta may be the greatest risk to performance. The beta exposure can be gained cheaply through indices and ETF's. Investors should not pay-up for beta because there is no skill in obtaining it. Beta exposure can be gained through traditional investment managers.
- ALPHA - This is the return that is unrelated to beta, non-market risk. It could strategy or manager-specific or it could be related to extracting risk premiums not found in market exposures. This risk could be gained through classic hedge fund managers. The risk will usually be lower than outright beta exposure. More alpha is usually at the expense of beta if not explicitly managed.
- GAMMA - These returns that are related to convexity. It could be strategy specific or through some structure like an option. Gamma exposure can be gained through global macro and managed futures or volatility traders. Investors should always be looking to add convexity to a portfolio.
The approach is simple. Measure your three sources of return and determine whether they represent what you want in the portfolio. Investors should be able to describe how these sources of return will be generated and how much should be gained and at what cost. Sorry for the pun, but investors will bag performance if done effectively.
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