How to generate alpha

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How to generate alpha

• Algafi Conference, 9th December 2004

Charles Nollet Chief Investment
Officer Credit Agricole Indosuez Charles.nollet_at_c
ail.lu
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Return to the basics alpha or IR ?
- Active management needs a benchmark (cash,
index or peers) - Value added is usually defined
in terms of information ratio, not alpha - Even
in a low nominal returns world, beta management
is important - In order to maximize the IR, you
need to have a good information coefficient
(correlation betweeen forecasts and realizations)
and a high breadth (number of independent
bets1/2) IR IC Breadth Stock picking
IR 0.02 10 20 pb Market timing IR
0.05 3 15 pb - Alpha rises with
information coefficient, volatility and score
(realization of the signal versus the forecast,
standardized) - On average, beta is close to
one and gives access to market returns - Alpha,
like IR, is close to zero and needs skill to
perform well
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Statistics always lie
- It is now well documented that illiquid
assets produce some unpleasant statistical
effects. - They are subject to high positive
autocorrelation of monthly returns, because of
time lags and heterogeneities. - Volatility is
underestimated, as can be correlation with other
asset classes.All things that point to improved
Sharpe ratio and MV optimizer outcomes. - When
beta is underestimated, alpha goes the other
way - Some studies say the true beta is almost
double (to 0.4) and the alpha can go from
positive to negative !
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A new way to build a portfolio ?
Any US investor is faced with the classic
Markowitz E-V choice between asset classes.
Those who seek higher returns (say, 10 ) are
directed to equities, without much
diversification prospects.
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Is leverage adding value ?
The expected returns and risks of most asset
classes can be raised through leverage. The
diversification process is thus
empowered. Back-testing up to the sixities show
the risks are well contained.
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Simplifying hedge funds
The above portfolio shows the benefits of a
 hedge fund style approach , applied to a pure
asset classes universe. This technique
recommended by BridgeWater Associates can also be
applied to the pension fund world, as shown by
Pimco Liability Hedging Portfolio s, september
2004).
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Our investment philosophy Time for a change ?

• Style Active management
• Asymetric link to the benchmark, mainly TAA
• International Diversification in Equities
• Expertise in asset classes optimal allocation
• Strong focus on budget risk ( TER or VAR) 

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We think it still holds, but needs to take
advantage of financial innovation
The old world Regional Equity Regional
Bonds Equities vs Bonds
The New World Old World Small cap
Equities Emerging Equities Growth versus
Value Sectors Emerging Debt High
Yield Commodities
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A few ideas in asset allocation
- We would allocate a bigger share to BRICs
than MSCI weights given expected currency
appreciation and equity markets excess returns
for Brazil, Russia, India, with the notable
exception of China (we prefer South-East
Asia). - In a world flirting with debt deflation
and flooded with liquidity, we would bet on a
basket of high yielding currencies - We cant
rule out a recession in a major european country
over the next two years we still bet on
lower short term rates than forwards we now
think the EUR is overvalued
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More on financial innovation .
External fund offers and multi-management
techniques are now widespread. Most of the time,
outperformance can be related to style, which
follow cycles. According to recent studies, the
diversification benefits of multi-management
seem to more than offset the double fees layers,
at least over the recent past.
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More on financial innovation...
On top of new asset classes and new fund
managers, we have access to - new ways of
packaging the ideas ( structured products, hedge
funds) - new financial instruments ( ETF
including less liquid assets ) - new risk
management techniques ( stress testing, expected
shortfall)
What happens is not the unavoidable but the
unexpected (J.M. Keynes)
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The rationale for a core - satellite approach
HOW ?
WHAT ?
Wide asset classes acceptance
External fund Managers
ALPHA or
Structured Products
New financial instruments
New Risk management Portfolio Construction
Techniques
Alternative Investments
Client Satisfaction ?