Alpha, beta and commodities

Dubai: Understanding "fund-manager-speak" is like keeping up with the changing dialogue of the modern teenager. What we sent them to school to learn isn't always what comes out at the other end.

Enter: "portable alpha", "exotic beta" and how to achieve it, which, in one word from Daris Delins of Castlestone Management, is "commodities". The A, B, C of what you need to know in order to make more than the market is about to unfold.

In short: A is for alpha, or performance against what you are trying to beat. B is for beta, or the risk. C is for commodities which according to Delins is the solution for market out performance at lowest risk in the medium term.

In a nutshell, according to Delins, "In five years, my basket of commodities which includes gold and oil, will be much more valuable than any other investment you can make today in financial assets and property".

In line with what he was sent to school to learn, Delins espouses the logic of diversified portfolio planning. His model though is uncommon: 20 per cent commodities, 20 per cent cash (for opportunity and defence) 20 per cent fixed income, 20 per cent hedge funds and 20 per cent into an equity strategy based on moving between holding equities long (when the markets are low), and long/short strategies at other times.

What's so special about this view? "It's all in the alpha provided by commodities", says Delins.

Two standout statements and the justification make the point: firstly, "I would be surprised if oil is $40 per barrel in a year or so, I would not be surprised if it was at $100 a barrel". Secondly, "I would be surprised if gold was at $400 an ounce in 12 months; not if it was at $1,000 an ounce."

The justification? "While others debate whether gold and oil are being over produced or under produced, I can see clear evidence of under-production," says Delins.

Transport and China are brought to the jury as examples of huge sectors where the demand for oil (for example) will remain strong.

"Further, we take the view that the demand for commodities will be driven upward by the need of fund managers to find alpha. Five drivers will steer more and more of them to commodities: they are under-owned, uncorrelated, they are a recognised defence against inflation and at times when geo-political issues remain, they are seen to be less risky," says Delins.

Back to the classroom for understanding the significance of the "commodities for alpha" message.

So, A is for "alpha". Which, according to UBS, can be defined as the "difference between a portfolio's risk-adjusted return and the return for an appropriate benchmark portfolio. Most active investors are trying to maximise alpha".

Put another way, (by Yahoo), "Example: suppose the mutual fund has a return of 25 per cent, and the short-term interest rate is five per cent (excess return is 20 per cent). During the same time the market excess return is nine per cent. Suppose the beta of the mutual fund is 2.0 (twice as risky as the S&P 500). The expected excess return given the risk is 2x9 per cent = 18 per cent. The actual excess return is 20 per cent.

"Hence, the alpha is two per cent or 200 basis points. Alpha is also known as the Jensen Index."

Put it my way: the alpha is the difference between what a market achieves (represented by its benchmark), and the performance of a specific fund manager.

This means the alpha represents the intelligence of the fund manager, and ideally that is translated into performance above a given market. This becomes the investor reward for using that manager instead of simply tracking the market.

Simplified: the alpha, or lack of it, tells us a lot about a fund manager, and/or a fund management style. With the portable alpha approach, (source UBS), the alpha of a manager or group of managers or strategy is transported to a target index. For example a pension fund allocates its fund to a bond manager who generates an alpha of 200bp yearly without an increase in credit risk.

In addition it swaps total returns of an equity index with the risk free rate. The end result is the total index return plus 200bp.

B is for "beta". Which, according to Yahoo is the measure of an assets "risk in relation to the market or to an alternative benchmark. A beta of 1.5 means that the assets excess return is expected to move 1.5 times the market excess returns.

"Example, if market excess return is 10 per cent, then we expect, on average, the stock return to be 15 per cent. Beta is referred to as an index of the systematic risk due to general market conditions that cannot be diversified away."

And so to C for commodities, for Delins the most obvious way of achieving A with minimum B.

The writer is the Managing Director of Mondial (Dubai) LLC.