The Importance of Alpha Diversification:
Increasing “Hit Ratio” in Multi-Asset/Multi-Manager Portfolios
John Donner, Senior Quantitative Analyst Multi-Asset Strategies
Rich Weiss,Senior Vice President Senior Portfolio Manager, Multi-Asset Strategies
- Alpha diversification and “hit ratio.” Alpha diversification is an important, if sometimes overlooked, element of portfolio construction when incorporating active strategies into multi-asset portfolios. We argue that a focus on alpha diversification among the underlying strategies can improve the “hit ratio,” or consistency of performance, across a larger multi-asset, multi-strategy portfolio.
- Building the best team, not simply seeking the best individual players. Certainly, the benefits of beta diversification are well known and widely accepted elements of portfolio construction processes, but manager selection to fill those asset allocations can often devolve into a quixotic search for an “all-star, five-star” lineup. Rather, we believe that carefully analyzing and selecting underlying managers who work well in concert can improve a multi-asset portfolio’s hit ratio. Greater consistency of alpha can add value by smoothing out the overall payoff pattern, reducing tracking error and risk, and enhancing longer-term return and wealth accumulation.
- Portfolio hit ratios for active TDFs are typically greater than the sum of their parts. We analyze a number of leading target-date providers and find that they are indeed improving consistency of performance—raising their hit ratios—through portfolio construction. However, the degree of improvement in the hit ratio varies, and depends on the correlation and distribution of underlying strategy alpha.
- Two ways to improve portfolio hit ratio—add return or improve diversification. For portfolios with little alpha, it makes sense to seek return to improve hit ratio. But when portfolio alpha is positive, better diversification improves hit ratio when alpha is positive. Indeed, a small amount of diversification can be strongly beneficial to the portfolio’s hit ratio.
- Skewness of the alpha distribution impacts hit ratio. Portfolio skewness derives from the skewness of the underlying funds, as well as the joint distribution of the funds. Again, we see a portfolio benefit to alpha diversification by reducing the negative skewness of the underlying funds.
- Lower correlations reduce portfolio variance, diversify away skewness, and improve portfolio hit ratio. Successful multi-asset, multi-manager portfolio construction demands diversification across beta, as well as individual manager alpha. In the final analysis, we see potential benefit from intentionally and systematically diversifying sources of manager alpha in the portfolio construction process.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Diversification does not assure a profit nor does it protect against loss of principal.