Alpha budgeting — Cross-sectional dispersion decomposed

Abstract

(All work in this paper is based on research conducted by the two authors working for Morgan Stanley and the findings have appeared in the Morgan Stanley Quantitative and Derivative Strategies publication as of March 2006). The last three years have witnessed markedly lower volatility in global equity markets, combined with higher correlation and lower dispersion. This has meant greater challenges for asset allocation and stock selection — alpha opportunities appear limited. How should the investment process be structured to maximise exploitation of the available alpha? We introduce cross-sectional standard deviation (or dispersion) as a metric for alpha opportunities, and show how it can shed light on the management of research resources, and on the optimal combination of investment strategies. The metric allows for objective alpha budgeting in the investment process. This involves both the identification of the key top-down drivers of dispersion in a given market regime, and the appropriate ‘alpha granularity’, which is linked to the optimal concentration of stocks in the portfolio. Alpha budgeting from top-down allocations — country, sector, size, style and beyond: using a novel decomposition framework of cross-sectional dispersion, we show the relative magnitude of top-down allocation decisions for several organisational structures. In Europe, sector investing continues to provide greater opportunities than country investing. Alpha opportunities and volatility — hedging opportunities: we establish a linkage between cross-sectional standard deviation (dispersion) and time-series correlation and volatility. Low return dispersion can be a business model risk for active stock pickers; we show how targeted exposure to volatility can be used as a hedge.Journal of Asset Management (2007) 8, 58–72. doi:10.1057/palgrave.jam.2250060 [ABSTRACT FROM AUTHOR]