Introduction to Alternative Investments

Poznan University of Economics and Business

Richard Van Horne, PhD, CFA, CAIA
October 2020

A Brief Review of Finance Theory Concepts

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Chapter 1. Introduction/Overview/Trends.

1.1. Alternative to What? – Traditional versus Alternative Investments

We have all heard of alternative assets. But have we taken the time to ask ourselves what the
words mean? What are alternative assets, and what are they alternative to? Traditional assets are
long positions, whether passively or actively managed, in traded stocks, bonds, and cash. In finance
theory, we earn a return by taking risk. Returns on these assets in the long run are influenced by
various factors or risks, such as economic growth, technological innovation and productivity
improvements, inflation trends, interest rate changes, position in the economic cycle, changes in
perception of credit risk, etc. For long positions in bonds, the risks include interest rate risk and
credit risk, among others. For long positions in stocks, the risks include company specific risks, such
as risk associated with new products, as well as general market risks, such as whether the economy
is entering a recessionary phase. For cash, the main risk is credit risk. For all three traditional asset
categories, there is the risk that inflation will erode the investor’s purchasing power over time;
history shows this risk to be greatest for cash, least for stocks, with bonds in a middle ground –
better than cash but still a poor hedge against inflation over the long term compared to stocks.

In the short run, returns are influenced by the above-mentioned factors and risks, as well as by
investor psychology and behavioral biases. In finance theory, risk is defined as volatility, measured
as the standard deviation of (typically monthly) holding period returns. Another measure of
investment risk, one that is much more transparent to the investing public but that is not commonly
treated by finance theory, is drawdown, the percentage decline from a market high to a subsequent
lower level. In this century alone already, the US equity market has had two bear markets each with
drawdowns of about 50%. Traditional (long-only) investing in the stock and bond markets is hard for
investors to sustain, from a psychological point of view, when the markets enter a severe bear
phase. Psychological stresses and behavioral biases are at the root of the phenomenon whereby the
average mutual fund equity investor in the United States earned 7.13% per annum on his equity

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mutual fund investments during the 26-year period ending December 31, 2016, a period when the
broad aggregate of equity mutual funds was up 8.69% per annum.1 Fixed income mutual fund
investor experience was similarly poor.2 Investors sell (in fear) when they should be buying, and buy
(in greed) when they should be selling. This is part and parcel of the psychological stresses
engendered by the extreme volatility of traditional (long-only) investing.

For institutional investors, the calculus is somewhat different. Consider the case of the Yale
University endowment and its Chief Investment Officer, David Swensen. When Swensen took over
management of the Yale endowment in 1985, it was invested long-only in a portfolio heavily
devoted to traditional stocks and bond exposures.3 Swensen wanted to increase the exposure and
allocation to the long-term growth potential of equity returns and to reduce the exposure and
allocation to the lower returns of bonds. He has brought the Yale portfolio allocation to 93% equity-
like exposure and just 7% bond/cash exposure.4 Yet, Swensen could not have afforded to have 93%
of the portfolio subject to a traditional equity asset class that would periodically loses over 50% of its
value in a bear market. The solution for Swensen, to maintain exposure to equity-like return
potential but without the exposure to a narrow and risky asset class (i.e., large cap US stocks), was
alternative investments.

Stated most simply, “alternative investments” are investment classes that are alternative to the
traditional investments (i.e., stocks, bonds, and cash). The main categories of alternative
investments can be described as longer-horizon and shorter-horizon investment programs:

1
Blanchett, David, Testing Dalbar’s Claims about Mutual Fund Investors, Advisor Perspectives, May 8, 2017.
https://www.advisorperspectives.com/articles/2017/05/08/testing-dalbar-s-claims-about-mutual-fund-
investors
2
These figures are from the analysis of David Blanchett, PhD, CFA, head of retirement research at Morningstar
Investment Management, LLC. Blanchett reports that the broad aggregate of fixed income mutual funds
returned 6.09% for the 26 years ending December 31, 2016 while the average fixed income mutual fund
investors, through poor timing decisions, earned just 4.80% per annum.
3
The Yale endowment exposure by asset class in 1985 was 83% in traditional long-only investments (62%
Domestic Equities, 17% Domestic Fixed Income, 4% Cash, and 5% Foreign Equity) and 12% in alternatives (8%
Real Estate, 2% Venture Capital, and 2% Leveraged Buyouts). http://investments.yale.edu/about-the-yio/
4
“The Yale Endowment 2015,” available at http://investments.yale.edu/endowment-update/

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The shorter-horizon investment program strategies fit nicely into a hedge fund structure. Among
the hedge fund-based alternative investments, one can see that the risks (defined as volatility and
drawdown) should either be less than that of traditional stock or bond investments, due to the
presence of short positions in the portfolio, or offer returns that are not very correlated to the stock
or bond market returns, due to the nature of the underlying assets not being stocks or bonds and
being sensitive to different risk factors. As for the longer-horizon alternative investments, these
should be buffered against equity market storms by the fact that the underlying assets do not
appear to change in price very often and by the fact that the investor is earning a premium for taking
the perceived risk of being invested in highly illiquid investment vehicles which own highly illiquid
underlying investments. All of the alternative investments listed above should provide the investor
with “equity-like” investment returns (that is to say, expected returns in the range of the historical
10% to 11% per annum earned by the SP500 over the past several decades) but with nowhere near
the measured risk (i.e., standard deviation of holding period returns) of the SP500, which has been
about 15% per annum over the past several decades. 5

In this way, Swensen of Yale was able to bring his bond/cash allocation down to 7%, increase his
exposure to investments with the potential for “equity-like” returns to 93%, yet not fear having his
portfolio halved in the event that the US equity were to suffer a 50% drawdown. This is the beauty
of the alternative investment, and this is the dynamic that has driven the huge increase in demand
for alternative investments by institutional investors and wealthy families.

Many observers of the hedge fund world resist characterizing hedge funds as an “asset class” distinct
from the fixed income or traded equity asset classes. They point out that hedge funds face the same
risk factors that traditional assets face. It is just that hedge funds deal with these risks, manage

5
From January 1988 through June 2016 (28.5 years), the S&P500 returned a compounded annual average of
10.33%, with an annualized standard deviation of monthly returns of 15.18%.

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these risk, trade these risks, and try to profit from these risks by employing techniques that long-
only investors shun, such as shorting, leveraging, and using derivative instruments, and by investing
in certain stocks and bonds that most long-only investors avoid, such as less-liquid securities and
higher risk securities. We will return to this topic later in this book.

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Chapter 3. Risk and Return: The Magic of the Portfolio.

3.1. Diversification and Portfolio Math

[Slide: Average Annual Rates of Return, first one]

Over the past hundred years of US capital markets history, the relationship between risk and return
is clear to see: Risky securities have had higher average returns than riskless securities. And among
risky securities, the greater the risk, the greater the expected or potential reward. Small company
stocks have had higher average returns than large company stocks. Long-term bonds have had
higher average returns than short-term bonds.

[Slide: Average Annual Rates of Return, second one]

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In this section, we will delve into that relationship, between risk and reward. Earlier, we examined
the power of compound interest to increase investor wealth over time. This phenomenon is
sometimes referred to as a “free lunch,” something that the investor gets for free, in exchange for
his patience. Well, the second “free lunch” in investing is diversification. In exchange for resisting
the temptation to concentrate his portfolio, if the investor spreads his equity investments across a
number of separate stocks, then he benefits from what I call the “magic of the portfolio” in reduced
risk but not a reduction in expected return, according to finance theory.

The power of diversification lies in the fact that some risks offset each other. We can go back to the
research work of Harry Markowitz in the late 1950s to find the origin of modern portfolio theory.
Markowitz measured risk in finance theory as the standard deviation of the holding period returns,
essentially the price volatility. Diversification reduces the portfolio volatility by combining various
individual stocks with different exposures to the relevant risks. For instance, if your store sells only
ice cream, business might not be so good in the winter. If you sell both ice cream and umbrellas,
you have something to sell all year round – you have diversified your product offerings. Similarly, if
your portfolio contains both automobile stocks and gold mining stocks, you have something in there
that will perform under economic conditions of boom as well as of recession. The key to
diversification is to assemble a collection of securities that are not highly correlated, one to another,
to various economic risks. In fact, it is best if some of the stocks are generally uncorrelated, or even
negatively correlated, one to another.

[Slide: JPM, P&G, CVX]

Let’s see how this works using real world data from three stocks: JP Morgan, Procter & Gamble, and
Chevron Corporation. Consider the industries these companies compete in: US domestic and global
banking; consumer products; and oil, gas, and refining. Which company’s business do you think has
the most exposure to changing economic conditions? Which company’s business should be more

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stable and less affected by overall changes in economic conditions? This kind of exposure to
economic conditions is reflected in a company’s changing financial performance, in its future
prospects, and hence in its stock price volatility.

Here is a histogram for each individual stock, depicting the distribution of monthly returns over a
twelve-year period in the run up to the global financial crisis.

You can see that most of the monthly returns for these stocks are bunched up in the middle of the
distribution. But there are plenty of returns that are not near the middle or average. Especially, the
returns for JP Morgan seem to be the most spread out, with Chevron next. Proctor & Gamble are
the most bunched-up in the middle of the three stocks. When the returns are away from the middle
or average, we call this “dispersion.” Every stock has some “dispersion” in its returns – the question
is, is it a lot of dispersion or just a moderate amount of dispersion? Well, if we can measure the
dispersion with a number, if we can quantify it, then we can compare the dispersion across stocks,
and even use that measure of dispersion to “scale” the stock’s return, to get a stock return that is
“corrected” for the amount of price volatility.

In fact, Markowitz faced this problem back the late 1950’s. He struck upon the idea of describing a
stock’s risk as the dispersion of its returns around its average return, and he decided that among the
various measures of dispersion, he would use the standard deviation of the returns to quantify the
“risk” of a particular stock. And to this day, we still use standard deviation as one of the two major
measures of investment risk.

So, the stock with the most dispersion will have the highest standard deviation, and will be deemed
to be riskier than others with lower standard deviation and less dispersion of returns.

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Back to our example: We can see that JP Morgan has the most risk, and that maybe P&G is next
because of two quite extreme results, and Chevron is probably the least risky of the three stocks.
Did you establish the same ordering earlier when I asked you to rank the stocks by likely exposure to
changing economic conditions?

We can see that the returns for P&G and Chevron are much more bunched up around the middle of
the distribution compared to JP Morgan. Yet, even these two more stable companies have some
hugely negative monthly performances. Chevron lost about 15% one month, and P&G lost more
than 10% in a single month six times, with one of those being a loss of 35%! I point this out just to
drive home the point that even companies in more stable industries can have wild swings in price.
Owning individual, single stocks is risky!!

[Slide: JPM, P&G, CVX, and portfolio]

What happens when we combine these three stocks into a portfolio? What would you expect the
histogram to look like?

I have added the histogram for the three-stock portfolio in the lower right-hand corner.

The first thing we notice is the three-stock portfolio exhibits much less dispersion than any one of
the individual stocks. Mixing the three stocks together has removed the severe negative outliers, as
well as the positive outliers to a great extent. The month when P&G lost 35% of its value was
obviously not the same month that JPM or CVX also had a large loss. JPM zigged when P&G zagged.
The individual monthly losses and gains cancel out to a great extent when we combine the stocks.
The portfolio risk is not the average of the risk of its components; it is much less than that. Yet while
the risk is greatly reduced when the stocks are combined into a portfolio, the portfolio return is

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simply the weighted average of the returns of the portfolio components. This is the “magic of the
portfolio;” diversification reduces the risk level but does not affect the portfolio return.

Above are five measures of risk; these are the standard deviations for our three stocks individually,
for the three-stock portfolio, and for a 500-stock portfolio (that is, for the SP500 stock index). Can
you guess which measure of risk belongs to which stock or portfolio?

The individual stocks all show risk measures above 20%, with the bank stock the most sensitive at
33% standard deviation. The three-stock portfolio reduces risk to such an extent that the risk
measure is reduced to 16.9%. And the 500-stock portfolio recorded risk of 14.6%.

The key is not just the volatility of the portfolio’s individual stocks. Rather, the key is how the
individual stocks vary in relation to one another.

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This chart shows the pair-wise correlations of the monthly holding period returns:

Stocks that move in lockstep and are completely correlated will have a correlation coefficient of
positive 1.0. Stocks that are perfectly negatively correlated will have a correlation coefficient of
negative 1.0. Let’s think about these correlations on the basis of the broad industry categories. The
correlation of oil/gas/refining to consumer products is close to zero; that is, the timing of the
sensitivity to common economic risk factors seem to be quite independent for these two. For
banking and consumer products, the timing of sensitivity to common risk factors are only mildly
positively related. Same for oil and banking. We enjoy the benefits of risk reduction with this
portfolio because the three stocks come from industries that are not highly correlated in the timing
of their economic sensitivities. Combining three banks or three drug companies or three airlines into
a three-stock portfolio will not do as much to reduce risk as will combining stocks from different
industries. Also, combining one airline, one trucking company, and one oil company into a single

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portfolio may not bring much diversification to the investor either, since all three may be highly
sensitive to a common risk factor, namely, changes in oil prices.

An oil company and a consumer staples company are subject very different economic risks. The
correlation of minus 0.04 (essentially zero correlation) tells us that the month to month
performances of these two, over the 12-year period overall, are essentially independent.

I mentioned that standard deviation is one of two major measures of investment risk. Now, I want
to move on to discuss that second risk measure, Beta.

Just before we get on to the discussion of Beta, I want to review diversification, risk reduction, and
the use of the normal distribution as an analytic framework in finance.

First, a word about the normal distribution.

I am sure you have seen pictures like the one above, that explain the statistical properties of the
normal distribution. Many phenomena in the natural world adhere to a normal distribution. For
instance, the height of adult males in Scotland is normally distributed. If you flip a fair coin one time,
there is a 50% chance of getting a “heads” and a 50% chance of getting a “tails.” If you flip that
same coin 100 times, your expectation (i.e., the theoretical outcome) is that you should get 50
“heads” and 50 “tails.” But, in fact, you may often get 48 “heads” or 56 “heads” or 39 “heads”
instead of the expected number of 50 “heads.” In practice, in the real world, the distribution of the
number of “heads” in a game of 100 coin flips has a mean or average of 50 and is normally
distributed around that mean of 50. If you play the 100-flip game 100 times, then the 100 results
may look like this if you plot them in a histogram:

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Hmmm. It does not look like the nice picture of the normal distribution shown on the previous page.
How about if we play the 100-flip game 1,000 times? The results might look like this:

It is getting closer to the shape of the normal distribution, but it still not smooth and symmetrical.

What is my point? The point is: Even a phenomenon that actually is normally distributed may not
look like it is normally distributed, unless you have lots and lots of data points. For the coin flipping
game, even 1,000 data points is not enough. You may have to play the game 10,000 times or
100,000 times before the actual results start to look like what we know to be the true normal
distribution that is a characteristic of the 100-flip coin flipping game.

So, even things that really are normally distributed may not look like they are normally distributed if
you don’t have enough data points. But what about things that we know for sure are not normally

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distributed? The returns over time from stocks and bonds are not normally distributed. Yet, in the
study of finance, we often use statistical models that assume that the returns of investment assets
are normally distributed. Beware! Even if they were normally distributed (which they are not) – if
you had 10 years of monthly return data for an investment, that would 120 monthly data points.
Given what we know about playing the coin flipping game 100 times or even 1,000 times, do you
think 120 data points for an investment asset is enough, even if it were normally distributed (which
it is not!)?

Extreme event risk refers to events that happen rarely but that are of great magnitude. Think of a
devastating flood, the kind of flood that only occurs once in a hundred years. Many systems in the
natural world follow a normal distribution, such as the height of adult males in Scotland, as
mentioned above. Just as an extremely tall person is rare, so in the natural world, an event with a
magnitude three standard deviations bigger than the average should happen once every 400 years,
more or less. (You can calculate that number using the diagram below.)

Really large events, compared to the average, happen only with a frequency that can be gauged with
reference to the extreme left-hand and right-hand “tails” of the normal distribution curve. A lot of
academic finance is based on the use of statistical models that require us to assume that events in
financial markets are also normal in distribution. But where human behavior comes into play, such
as in the pricing of stocks and bonds, the assumption of normality is violated. But we use the models
anyway, including in quantitative risk management. Extreme events in finance, measured by how
different the event is from the average, occur much more often than they should if the events were
distributed normally across time. The “tails” of the distribution of events in finance are “thicker”
than the tails of the normal distribution; this is where the term “fat tails” comes from. Investors
need to recognize this fact, accept this fact, and plan for it both in portfolio construction and in risk
management.

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Next, diversification and risk reduction: I described the benefits of diversification earlier with
reference to combining stocks together into a portfolio; we rely on the relationship of each stock to
every other stock through the pair-wise correlations to reduce the overall risk in the portfolio. I
want to discuss diversification and risk reduction in a different way now, to lead to our discussion of
Beta, the second measure of investment risk.

The way that we usually explain the concept of diversification in the stock portfolio is with reference
to unique risk and to market risk. A unique risk can also be referred to as a stock-specific risk. It is a
risk that is unique to a particular company, a risk not shared even with other companies in the same
industry. Examples could be the retirement or death of the top manager, a faulty product, or the
loss of a key customer. A market risk, on the other hand, is a more general economic risk that could
affect any company – or all companies. It is not so specific as to affect only one company, as a
unique risk does.

Some examples of unique risk or company-specific risk could include:

a product quality problem at a company such as Boeing or Johnson & Johnson
leadership continuity at a company such as Berkshire Hathaway with Warren Buffett or
Apple with Steve Jobs
proprietary technology such as drug development or patent expirations at Pfizer or Amgen
risk control at a company such as JP Morgan in the “London Whale” trading scandal

In contrast to this, examples of market risks could include changes in economic growth, changes in
inflation expectations, changes in corporate tax rates, and trade wars. These are risks that broadly
affect many different companies across industries. Note that these kinds of risks do not affect all
companies to the same extent. For instance, the risk of slower overall economic growth may affect
banks and industrial companies more than it may affect consumer products companies and utility
companies. Yet, slowing growth is still a market risk – not a company-specific risk.

We usually represent this idea of unique and market risks in a picture like this:

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In this diagram, the number of securities in your portfolio is shown on the horizontal axis – so if you
have a single stock in your portfolio you’re at the extreme left-handside, and if you have a large
number you’re at the righthand side. The vertical axis shows the extent and type of risk in the
portfolio.

When you own one stock, you have a lot of unique risk or company-specific risk. Remember that
Proctor & Gamble dropped by 35% in a single month (in March 2000 due to a warning of lower
future profits, a company-specific event). As you add stocks to your portfolio, the company-specific
risks start to cancel out, based on the pair-wise correlations being less than +1.0. Even as few as
three stocks pulled from different industries goes a long way to canceling out company-specific risks,
as we have demonstrated. This graph shows how the unique risk resident in a portfolio falls as the
number of stocks increases. Research has shown that a portfolio of about 20 stocks is a large
enough selection to bring the overall portfolio risk down toward the level of the market risk. That is,
a portfolio of 20 stocks likely has a dispersion of return, and a standard deviation, that is about the
same as for the SP500 stock index.

But diversification can only bring portfolio risk down to a certain level. Diversification can bring
portfolio risk down to the level of market risk, but not below that. So, a well-diversified investor
should have risk similar to the market risk, and he or she should earn a return that is in line with that
market risk, since that market risk cannot be diversified away. So, in finance theory, and in real life,
company-specific risk can be removed through diversification. And in finance theory, an investor
should not earn a return for bearing company-specific risks since those risks can be diversified away.
You may find this to be counter-intuitive, so let me repeat this statement: “In finance theory, an
investor should not earn a return for bearing company-specific risk that can be diversified away.”
Besides being counter-intuitive, this idea is the source of great controversy and also lies at the heart
of hedge fund investing. As an investor friend of mine once remarked to me: “If you diversify your
portfolio, then you ‘diversify’ your return.” He meant, if you own too many stocks in your portfolio,
then your return will approach the return of the index. If you want to outperform the market, your

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portfolio has to be different than the market portfolio – you have to take company-specific risks to
outperform. So, obviously, you do get compensated for taking unique, company-specific risks, no
matter that finance theory tells you that you don’t. That is what stock-picking and fundamental
analysis is all about.

So, we see that finance theory runs into the reality of the investment world.

There are plenty of investors who have made huge amounts of money by taking company-specific
risks. For instance, investors who bought Microsoft in the 1980s and held the stock faced many
company-specific risks, risks that affected Microsoft but no other companies, such as risks around
the adoption of the DOS operating system by PC manufacturers and the lawsuit by the US
government against Microsoft that dragged on for many years. Those investors might argue that it
was those precise, unique risks, not the market risks, that lead to the extraordinary returns. We
could tell a similar story for investors bearing company-specific risks when investing in Walmart, or
Boeing, or Amazon, or hundreds of other companies.

Active management is about gauging how different companies will respond in different ways to
overall market risks that affect all companies. But active management can also be about analyzing
company-specific risks (such as patent or product approval or R&D success for a drug company) and
profiting by taking on a risk that could be diversified away.

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We have introduced the concept of market risk, defined as the underlying risk that cannot be any
further diversified or reduced. And we have also introduced the idea of a broad portfolio, such as
the SP500, where the portfolio risk is the same as the market risk. Now, we are ready to move on to
Beta.

3.2. Beta

Modern Portfolio Theory starts with Harry Markowitz. We already covered how he decided to use a
measure of the dispersion of stock returns – the standard deviation – as a way to quantify
investment risk. And we covered his explanation of how the pair-wise relationships among all the
stocks is the key to understanding the power of diversification. Now, we will look at how Markowitz

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represented his findings in the graphical form of the Efficient Frontier, where he depicted the trade-
off between return and risk.

The return is plotted on the y-axis, with the risk on the x-axis. The Greek letter “sigma” is used to
represent the standard deviation. E(r) stands for expected return. Each individual stock (the black
dots) occupies its own position in this return vs. risk space. Investors will always try to move in the
direction of higher return and lower risk. That is, investors always want to move in the direction
toward the upper left of the graph. We have seen that combining stocks into a portfolio can lower
the overall risk without lowering the returns. (The arithmetic returns in a portfolio are just the
weighted average of the arithmetic returns of the stocks in the portfolio.) So, in the Markowitz
framework, there will always be some various portfolios of stocks that will be superior for the
investor to own than individual stocks. And also, there will be certain portfolios that will be superior
to other inferior portfolios. All this in the context of getting as much return as possible for any given
level of risk. In the graph, this means that the black dots (that is, the individual stocks) can be
combined into a portfolio in such a way that the combined stocks do not lie on a straight line
between or among the selected stocks – no, the combined stocks (shown by the red dots) actually lie
further to the upper left, in the direction of lower risk for the same amount of return.

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%
0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

JPM CVX PG PORTFOLIO SP500

Above is a Markowitz chart from our previous example, with data on the three stocks, JPM, CVX, and
PG. Again, the return is plotted on the y-axis, with the risk (standard deviation) on the x-axis. The
yellow dot is the risk/reward position of the three-stock portfolio. For about the same return, the
risk is much reduced, compared to holding the three stocks individually. The investor is better off

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with the portfolio than with the individual stocks. He or she is closer to the upper left portion of the
chart area, the area of higher return and lower risk.

Of course, there are thousands of stocks, which can be combined in different weights to form an
infinite number of different portfolios. On what basis will the investor decide what to do?

Markowitz explained that the investor can concentrate his attention just on those portfolios that lie
on the “frontier” which is a curved line that defines the outside boundary of all the possible
portfolios. This is the edge of the collection of all possible portfolios that faces toward the upper left
portion of the graph. One thing that all of these frontier portfolios have in common is that it is the
highest return portfolio for that particular level of risk. So, the investor can choose among the
frontier portfolios based on the investor’s own preference for how much risk he can handle and how
much return he wants to get. These frontier portfolios are distinguished from the less-desirable
interior portfolios by being referred to as “efficient” portfolios; hence, the term “efficient frontier.”

There is software that we can use now to perform the calculations to construct the efficient frontier.
The calculation technique is called “mean-variance optimization.” “Mean” refers to the average
return, and “variance” refers to the risk measure, standard deviation being the square root of
variance. So, the software optimizes the “mean” return for any level of “variance” or risk. Here is
how it works: for a given level of risk, the computer will look through all possible combinations of
stocks in the database to find the combination or portfolio that has the highest return. The
computer will then move on the to the next risk level, and repeat the process. Eventually, the
computer will have determined the highest expected return portfolio at every risk point along the
graph. When all the “efficient” portfolios are plotted, they form the outer boundary curved line that
we see on the chart.

When Markowitz did his PhD research in the late 1950’s, he developed this framework using a
relatively small number of stocks. The reason was: he had to do all the pair-wise correlation and

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portfolio variance calculations by hand. As the number of stocks grew, the number of calculations
grew exponentially.

A few years later, William Sharpe proposed an innovation that allowed Modern Portfolio Theory to
advance and to be more accessible. Markowitz, correctly of course, posited that the benefits of
diversification and the theory of the portfolio derive from the relationship of each stock with every
other stock in the portfolio. True, but hard to use and even harder to scale up. Sharpe combined
Markowitz’ framework with his own insight about the primacy of market risk. If the only risk that
matters – and the only risk in finance theory at least that is compensated – is market risk, then
Sharpe figured out that he could measure each stock’s sensitivity not to every other stock, but rather
to the overall market portfolio of stocks that corresponds to the market risk. So, for a 20-stock
portfolio, the number of calculations falls from 380 in Markowitz to 20 in Sharpe, a 94% reduction.
And for a 500-stock portfolio, the number of calculations falls from 249,500 in Markowitz to 500, a
99.8% reduction! Sharpe called his model a capital asset pricing model, in that the model could be
used to estimate the prices of “capital assets” such as stocks and bonds.

Sharpe called this relationship, of the individual stock to the overall market, Beta. Beta measures
how sensitive the stock is to overall economic factors relative to how sensitive a portfolio of all
stocks would be to those same economic factors. But analysts usually use a short-cut way of
describing Beta, to say that Beta is a measure of how risky a stock is relative to the overall market.

So, just to review: There are unique risks or company-specific risks that impact individual stocks.
There are also market risks derived from macroeconomic factors that will impact all stocks. Beta
measures the sensitivity of the individual stock to these common market risks, without taking into
account the stock’s company-specific risks. Companies that are more sensitive than average to the
macro factors will have Beta measures over 1.00; most banks have Betas over 1.00. Companies that
are less sensitive than average to macro risks will have Beta measures under 1.00; supermarkets and
toothpaste companies have Betas under 1.00.

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One way to measure a stock’s Beta is in a regression analysis. The Beta is the slope of the ordinary
least squares line that best fits the data. We can also understand Beta by simply looking at a scatter
plot of the stock’s monthly returns plotted against the monthly returns for the market.

Apple, Feb '06 thru Nov '16

40.00%

30.00% y = 1.2259x + 0.0149

R² = 0.3099
20.00%

10.00%

0.00%
-40.00% -30.00% -20.00% -10.00% 0.00% 10.00% 20.00% 30.00% 40.00%

-10.00%

-20.00%

-30.00%

-40.00%

The x-axis is the return of the SP500 index in any given month, and the Y-axis is the return for the
individual stock in that month. Each dot represents a single month in two pieces of information: the
return for the SP500 in that month and the return for the individual stock in that same month. So, if
we have 10 years’ worth of data, we will have 120 dots in the scatter plot. If the stock, on the y-axis,
goes up by more than the market in an “up” month, and if it goes down by more than the market in
a “down” month, then that stock is said to be “riskier” than the overall market, and the slope of line
that fits the dots will be steep. The slope of the line, which is the Beta, will be greater than 1.0.

Here is the scatter plot for Apple, for a 10+ year period into and after the global financial crisis. The
slope of the Beta line is steep. It is 1.22, indicating that the stock, in general, goes up more and goes
down more than the overall market. Apple is more sensitive to macro factors than the overall
market; it is “risker” than the average stock in the market.

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 Berkshire Hathaway, Feb'06 thru Nov'16
40.00%

30.00% y = 0.5858x + 0.0048

R² = 0.2455
20.00%

10.00%

0.00%
-40.00% -30.00% -20.00% -10.00% 0.00% 10.00% 20.00% 30.00% 40.00%

-10.00%

-20.00%

-30.00%

-40.00%

Here is the scatter plot for Berkshire Hathaway. This is Warren Buffett’s company, a diversified
conglomerate that is active in multiple industries. I have used the same scaling on these two graphs
so that you can compare the slopes of the fitted lines. The slope of the Beta line is shallow. It is
0.59, indicating that the stock, in general, goes up less and goes down less than the overall market.
Berkshire is less sensitive to macro factors than the overall market; it is less “risky” than the average
stock in the market.

Now, let’s look at the Betas for our three stocks: JPM, CVX, and PG.

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You can see a pattern here, a general positive relationship between JPM stock and the overall
market. We can measure the relationship numerically or quantitatively by calculating the stock’s
Beta using regression analysis.

Here is the same chart with the regression line and the data.

The slope of the line is 1.59. The Beta for JPM stock over the time period is 1.59. We can say that
JPM stock is 1.59 times as “risky” as an investment in the SP500.

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Here is the chart for Chevron, CVX. Chevron has a Beta of 0.60. Chevron was 0.60 times as risky as
the overall market during the time period under study.

And Proctor & Gamble had an even lower Beta. P&G was 0.28 times as risky as the overall market
during the period.

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What about our portfolio of the three stocks together? The portfolio was about 0.83 times as risky
as the overall market – which happens to be the average of the three Betas: 1.59, 0.60, and 0.28

Which brings us to an important and interesting difference between the two major risk measures. In
the case of standard deviation as a risk measure, you will recall that the portfolio standard deviation
is less than the weighted average of the individual stock standard deviations, due to the pair-wise
correlations being less than positive 1.0. But the portfolio Beta is simply the weighted-average of
the Betas of the individual stock Betas. Why this difference? What is going on here?

The standard deviation measures the total risks of the stock – both the company-specific risks and
the systematic, market risks, together in one measure. As we combine stocks into a portfolio, the
unique risks get diversified away, leaving just market risk. So, we should not be surprised that the
standard deviation measure of risk for a portfolio would be less than the average of the standard
deviations of the various stocks; after all, the company-specific risks have largely disappeared
through the “magic of the portfolio.” But Beta measures only the systematic risk of the stock; Beta
does not measure the unique risks of the stock. So, there is no reason that the Beta of the portfolio
should be less than the average of the Betas of the stocks in the portfolio; the diversifiable unique
risks were never reflected in the stock Betas to start with.

In any event, we find it useful to use both risk measures when investing and when constructing
portfolios.

3.3. Alpha

William Sharpe is famous for the Capital Asset Pricing Model (or CAPM). Sharpe was focused on the
relationship between an individual stock and the overall market. His model was suited to estimating
the market risk of a single stock or an unmanaged or passive portfolio. Here is the formula for
Sharpe’s CAPM:

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 𝐸(𝑅𝑖 ) − 𝑅𝑓 = 𝐵𝑖 ∗ (𝐸(𝑅𝑚 ) − 𝑅𝑓 ) + 𝜇𝑖

A few years later, in 1968, Michael Jensen applied Sharpe’s model in a different context. In the mid-
1960s, there was a debate going on about whether mutual fund managers were doing a good job or
not, and how an investor could know. The crude approach was simply to compare the funds’ return
to the market’s return, to see which was higher. When the market was going up, the fund manager
who bought the riskiest stocks would do the best. But is that the best way to evaluate fund
managers?

Jensen applied Sharpe’s model not to individual stocks but to US equity mutual funds as if the funds
were individual stocks. Jensen raised the case of an actively managed portfolio where the manager
was skillful at forecasting market movements or at picking stocks. Jensen said that such a portfolio
should earn more than the normal return for its level of risk. He allowed for such investing ability by
relaxing Sharpe’s assumption about the regression line passing through the origin or the zero-point
on the graph. In Sharpe’s simple CAPM, Sharpe assumed that the market return would be the single
factor that would explain everything about the stock’s return. So that, if the market return were
zero, then the stock’s return should also be zero. That’s why the Beta line in Sharpe’s CAPM would
have to pass through the origin, or the zero-zero point, on the graph. Jensen applied the model to
funds, not to individual stocks, and Jensen allowed the possibility that a skillful fund manager could
earn a positive return even in a month where the market return was zero.

So, Jensen allowed the regression analysis to fit a line to the data, recording both the slope of the
line and the intercept. The Beta, the slope, tells us the sensitivities of the fund relative to the
market, same as in the Sharpe model. But Jensen’s innovation is in the intercept, which Jensen
referred to as the Alpha, and which we sometimes call Jensen’s Alpha. The slope of the line is the
Beta or risk of the fund relative to the market. Where the line crosses the y-axis tells us whether the
manager is providing a positive or a negative return, adjusted for the risk that the manager has
brought into the portfolio as measured by the portfolio’s Beta. So, if a manager beats the market
but does so only by taking on huge amounts of risk, then the slope of the regression line will be
steep (i.e., a high Beta) and the intercept will be negative, showing that the manager actually
underperformed the market, when adjusted for the risk of the portfolio. Jensen applied his
innovation to 115 mutual funds in his academic article that was published in 1969. He found that no
mutual funds did better than just owning the market portfolio, on a risk-adjusted basis. In 1969, he
concluded with advice that is still given to retail investors today: minimize expenses, and buy a
portfolio as fully diversified as possible.

Here is Jensen’s version of the Sharpe’s capital asset pricing model, in the form of an equation.
Jensen solved this equation for historical data using regression analysis to estimate the Alpha and
the Beta parameters.

𝐸(𝑅𝑖 ) − 𝑅𝑓 = 𝛼𝑖 + 𝐵𝑖 ∗ (𝐸(𝑅𝑚 ) − 𝑅𝑓 ) + 𝜇𝑖

This innovation by Jensen is still the key to our thinking about active portfolio management. But it
has taken many decades for Alpha to become wide-spread as the key to portfolio management

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performance evaluation for active managers. As investors have become more adept at measuring
the performance of their active managers, they have come to realize that most active managers are
not beating the market on a risk-adjusted basis, after expenses. This is one reason for the rise of
passive- or index-investing in recent years.

As it happens, very soon after Sharpe published his capital asset pricing model in 1965, other
researchers investigated and published their own findings. They found that the CAPM is not actually
consistent with what happens in the real world. There were several problem areas. One had to do
with small company stocks: given the Beta of these stocks, the returns were higher than they should
have been according to the CAPM. Same for value stocks; that is, returns for owning stocks with
lower price-to-book ratios were too high for the amount of Beta that they exhibited.

In fact, Eugene Fama (yes, the same Fama that gave us the Efficient Market Hypothesis) and his co-
researcher Ken French in 1992 published important research on the “small stock” and the “value
stock” phenomena. And, the debate has been going on since 1992. Fama, sticking to the position
that markets are always efficient, is more or less forced to argue that small stocks return more than
large stocks, and that value stocks return more than growth stocks, only because they are riskier.
Any other explanation for the strange result would not be in keeping with the efficient market
hypothesis. Others argue that the higher returns are anomalies, not due to higher risk, but based on
some market inefficiency or some investor behavioral biases, and that the higher than expected
returns prove that markets are not efficient when it comes to setting the prices for small stocks and
value stocks.

Here is the formula for the Fama-French 3-factor model. You can see that is a modified version of
the capital asset pricing model formula shown above:

𝑟𝑖𝑡 − 𝑟𝑓𝑡 =∝𝑖𝑡 + 𝑏𝑖𝑡 𝑅𝑀𝑅𝐹𝑡 + 𝑠𝑖𝑡 𝑆𝑀𝐵𝑡 + ℎ𝑖𝑡 𝐻𝑀𝐿𝑡 + 𝑒𝑖𝑡 ,

In 1993, Jegadeesh and Titman found that there is a phenomenon related to stocks that have gone
up in price recently – that is, stocks with positive price momentum – that cannot be explained by the
efficient market hypothesis or by the CAPM. They found that stocks that have gone up the most in
the past twelve months, tend to continue moving up in price over the next several months. These
future returns are more than the returns that one would expect based on the Beta of these stocks.
And this momentum phenomenon, of course, is also contrary to the efficient market hypothesis,
which says that stock price changes are random in the short term, and based on new information.

The fact that the CAPM was not a realistic model in relation to small company stocks, value stocks,
and stocks that exhibited recent price momentum lead researchers to expand the CAPM to include
these new risk factors. A model including size and value, along with the original market factor, is
known as the Fama-French 3-factor model. And the model that includes the momentum factor is
known as the Carhart 4-factor model. Here is the formula:

𝑟𝑖𝑡 − 𝑟𝑓𝑡 = ∝𝑖𝑡 + 𝑏𝑖𝑡 𝑅𝑀𝑅𝐹𝑡 + 𝑠𝑖𝑡 𝑆𝑀𝐵𝑡 + ℎ𝑖𝑡 𝐻𝑀𝐿𝑡 + 𝑝𝑖𝑡 𝑀𝑂𝑀𝑡 + 𝑒𝑖𝑡 ,

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A model that includes these additional important factors, in addition to Sharpe’s original market risk
factor, will be able to identify and explain a larger proportion of the stock’s or the fund’s returns. If
more of the fund’s return can attributed to taking risks (such as market risk or small company risk or
value stock risk or high price momentum risk) then the less of the return will be seen to be due to
the manager’s skill in timing the market or picking stocks. In other words, the more of the return
that is compensation for taking risks (which is what Beta is), then the less of the return will be seen
to be Alpha (which is the main thing we are always looking for as hedge fund investors!).

And the beat goes on. More recently, researchers have noticed that stocks with low Beta (or low
risk in general) had higher returns than one would expect, based on the Beta of those stocks. Similar
for stocks that pay dividends: stocks with good dividends had higher returns than you would expect,
just based on the market risk of the stocks. And “high quality” companies – that is companies with
strong balance sheets, lower than average leverage, stronger cash flow – also tend to return more
than indicated by their Betas.

Nonetheless, even with these flaws, the CAPM is a useful framework for thinking about risk and
return, and is still in wide-spread use in corporate finance, if to a lesser-extent in investing. And the
basic CAPM approach still serves as the basis for analysis in investments, as we will see shortly.

Besides the CAPM and Beta, Sharpe is also best known for the Sharpe ratio. This is a measure of
return, adjusted for the amount risk taken to earn that return. It is interesting to note that in the
Sharpe ratio, Sharpe used standard deviation, not Beta, as the measure of risk. Sharpe used the risk
measure that captures the total volatility or risk of the stock or fund, not just its movement in
relation to the overall market. Sharpe’s method captured both market risk and company-specific
risk when calculating the fund’s reward-to-risk ratio. Furthermore, Sharpe adjusts the fund’s return
for the fact that investors can earn the risk-free rate of return taking no risk at all. He makes this
adjustment by deducting from the fund’s return the risk-free rate of return. The result is known as
the fund’s “excess return,” its return in excess of the risk-free rate.

𝑓𝑢𝑛𝑑 𝑒𝑥𝑐𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛 𝐴𝑖 − 𝑅𝑓

𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜 = =
𝑓𝑢𝑛𝑑 𝑟𝑖𝑠𝑘 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 𝜎𝑖

A higher Sharpe ratio indicates a higher risk-adjusted performance. Last year, I completed some
research using a dataset of 1,100 hedge funds over a twelve-year period, 2005 through 2016. The
average Sharpe ratio was 0.53. Fewer than 10% of the hedge funds had Sharpe ratios over 0.75, and
only 4% were above 1.0.

Some investors use the Sharpe ratio to evaluate actively managed funds. Some use Alpha. And
some use both.

The popularity of the Sharpe ratio can be attributed to its ease of calculation, ease of interpretation,
and wide applicability across different kinds of investment assets; the Sharpe ratio is one of the few
tools we have to help us compare apples to oranges when picking investments. But be careful when
using the Sharpe ratio in the case of funds or investment assets that have restricted or poor liquidity.
Small cap stocks are less liquid than large cap stocks. Emerging market stocks are less liquid than

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developed market stocks. Corporate bonds are less liquid than government bonds. High yield bonds
are less liquid than investment grade bonds. And distressed debt and municipal bonds are just not
very liquid at all, period. When assets trade “sticky” in the secondary market, or when assets don’t
trade every day and the end-of-month market-to-market may be stale, or when the mark-to-market
is based on a price derived from a credit spread – in all these cases, the standard deviation of the
monthly returns will likely be understated versus the true volatility or risk of the asset. This means
that the denominator in the Sharpe ratio is too small, and the Sharpe ratio will be overstated.
Illiquid assets likely have inflated Sharpe ratios and look better than they actually are. Beware.

We have covered a lot of ground in this chapter: Markowitz and diversification and the “magic of the
portfolio”; from the concepts of unique risk and systematic market risk to two quantitative measures
of risk, Beta and standard deviation; from Sharpe’s CAPM and Beta to Jensen’s innovation and
Alpha; from Sharpe’s oversimplified CAPM to the Fama-French 3 factor model and the Carhart 4-
factor model, which are in standard use today for fund evaluation; from what looked like lots of
Alpha in an oversimplified model, to less Alpha in a better defined and more complex model.

There have been subsequent extensions of the above discoveries. Investors – both passive investors
and active investors, including some hedge fund managers – have applied these developments from
academic finance to the business of investing. This approach is called Risk Factor investing.

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