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Magazine Issues » February 2013

INTERVIEW: The skill that is beta

E RepettoDirectors at Dimensional Fund Advisors include academic luminaries who have shaped how returns are measured. Nick Fitzpatrick reports.

If alpha were a stone it would be a rare one and wherever fund managers found it, there’d be an academic, loupe to eye, who sees only sparkly grit.

Damn that golden era in economics in post-war America! Without it, investors would think any positive portfolio return was produced by fund manager skill and
pay gratefully.

But thanks to academics who brought science to bear on portfolio management, skill can be revealed not as alpha, but beta. In other words, the portfolio went up because the market did.

If there is one asset management firm with no excuse for confusing beta for alpha it is Dimensional Fund Advisors based in Austin, Texas. Dimensional has a strong link with academia that goes right to the centre of the alpha debate.

Most notably, this is through Kenneth French and Eugene Fama of Dartmouth College and the University of Chicago, respectively. In 1992, they devised the three-factor model, a way of pricing stocks for a diversified portfolio, and it revealed that small caps and value stocks increased returns.

French and Fama are two of eight academics with a directorship at Dimensional. Myron Scholes, famous for the Black-Scholes equation, is another.  As well as its directors, the firm employs a “resident scientist”, Nobel laureate Robert C Merton.

The prestigious University of Chicago Booth School of Business takes part of its name from David Booth, Dimensional’s founder, chairman and its co-chief executive.

The other co-chief executive is Eduardo Repetto. Argentine-born Repetto is a past winner of the William F Ballhaus Prize from the California Institute of Technology for his thesis on aeronautics. He is a rocket scientist, according to a colleague.

He is also Dimensional’s chief investment officer. Surely he would not confuse alpha with beta, so what is the difference?

“It depends who you speak to,” says Repetto.

“Historically, small cap stocks were thought to give an excess return in a portfolio calculated using the CAPM [capital asset pricing model]. Small caps were seen as an alpha source.”

The CAPM, developed by various academics in the 1960s, is used to price a portfolio based on the market risk that stocks are exposed to. A beta of one means a security’s level of risk and return will move in tandem with the general market risk and return. Small caps were seen to have a negative beta, making them a potential source of alpha if chosen correctly by fund managers.

“Then French and Fama came along with the three-factor model and the idea that small cap returns were an alpha source relative to the CAPM disappeared,” says Repetto.

The three-factor model revealed small caps – and also value stocks – to be forms of beta; in other words, they were influenced more by broad market risk than people had realised.

“The three-factor model showed small caps and value were just two more betas that were not captured in the initial CAPM model.”

Therefore, a lot of what investors consider alpha is really beta, says Repetto.

Since 1981, when Booth founded the firm in Brooklyn, New York, Dimensional has been putting its brain power into investment strategies based on enhanced index methodologies, what some call “smart beta”. Smart beta indices are designed to provide returns that are better than traditional passive management, usually by tilting an exposure to a sector like small caps, but for fees much cheaper than traditional active management.

Dimensional’s core equity strategies are based on French and Fama’s research and are designed to capture premiums associated with size, value and – since last year – profitability.
Small cap was Dimensional’s first strategy, dating back to 1981 when Booth created his own index designed to capture the best premiums from the sector.

In theory, the timing could not be better for Dimensional today. The US asset management industry has a heightened interest for index-based investment while also pushing for lower fees.

Repetto says fees are subject to one of the most significant changes in US investment management in the past five years.

“Fee trends are benefiting low cost managers and providers that have something value-added to bring.”

Smart beta is an area that index providers such as MSCI also have a great stake in and it is also of interest to exchange-traded funds.

Questions about the right fee for what is an index return – albeit an enhanced one – will no doubt follow. At present, the average fee for Dimensional funds is 30 basis points (bps), ranging from 8bps to 65bps.

So far, people seem to accept this. As evidence, Repetto can offer Dimensional’s assets under management, which were $152 billion (€112 billion) before the financial crisis and are $270 billion now.
At business pitches Dimensional can usually expect to compete with fund managers such as Pimco and Aberdeen Asset Management, depending on strategy and asset class. Having such brain power on board is an obvious selling point for Dimensional.

Repetto, though, acknowledges it can be a challenge for the firm to explain its scholarly strategies to consultants.

But, hopefully, the consutants at least know the difference between alpha and beta.

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