Janus: The Roman god of alpha/beta separation?

Date: Monday, March 26, 2007
Author: All About Alpha

Janus, the company whose logo looks like an early version of that face transplant performed in France last year, has come out with an intriguing offering that aims to separate alpha and beta investment decisions.  It’s called “Modular Portfolio Construction” and according to Janus’ website, it’s targeted squarely at financial advisers.

In fairness, the “face transplant logo” is actually a representation of the Roman god of new beginnings named - you guessed it, Janus (as in Jan-uary).  If Modular Portfolio Construction catches on, Janus hopes it might someday be recognized as a new beginning for retail portfolio construction.  Say the rocket scientists at “Janus Labs”:

“Today’s complex markets require more innovation and comprehensive solutions to investing than ever before.  Traditional approaches, nine-box style grid, and core/satellite models may not meet those expectations.

“What’s needed is a flexible framework hat will help your clients take full advantage of all the market has to offer today - all of its differentiated and non-correlated choices, the latest in active management and near-term macroeconomic opportunities.”

The approach involves four separate buckets: “core”, “alpha”, “alternative” & “tactical”.

  • “Core” (a.k.a. beta): described by Janus as then “workhorse” of the portfolio.  Curiously, it also “seeks to limit downside risk”.  Short of overpriced portfolio insurance, we’re not sure equity market beta provides such protection.
  • “Alpha”: active small/mid-cap management, “concentrated styles”, and “unconstrained portfolios” (nee: hedge funds?)
  • “Alternative”: (they start to lose us here)  Features a “low correlation with core and alpha”, “potential positive returns regardless of market”, and “lower standard deviation”.  To us, this sounds like alpha.   
  • “Tactical”:  Janus says this portion of the portfolio can “potentially capitalize on macro-economic trends” by actively trading beta in the form of ETFs.

As you can see, this is really a half-step toward a pure alpha/beta approach.  For example, the “Alpha” bucket actually contains a lot of beta simply because it includes active long-only managers.  The portfolio construction process would therefore need to under-invest in “core” or risk having too much beta.  It seems the “alternative” bucket can better be described as “alpha”.  “Tactical” can be either high-alpha or low-alpha depending on the net market exposure.  GTAA managers who have parceled off their active overlays into global macro-funds would be the first to say that trading beta can produce pure alpha as long as the portfolio remains market-neutral.   

We contacted Janus (contact info) for a copy of a white paper they wrote on this topic for financial advisers (although curiously it says “for institutional investors only” at the bottom of every page).  It’s an interesting read - especially if you are an adviser looking for a new way of doing things and some way to differentiate yourself. 

In that white paper, Janus points to the performance of the Harvard, Yale & Stanford as inspiration for Modular Portfolio Construction - even throwing in the following chart:

Echoing several of the explanations proposed by the Economist a few months ago, Janus attributes the success of these funds to a) portfolio construction, b) alternative asset classes, and c) “clearly defined goals” and d) long time horizons. 

The Core Portion 

The white paper goes on to say that the “core” module is the primary tool for customization by an advisor (based on a client’s time horizon and risk tolerance).  By expressing these unique needs in the form of simply asset allocation, Janus says advisors can avoid the complexity of full portfolio customization.

The Alpha Portion 

Strangely, the paper says the (low correlation) “alpha portion” of the portfolio actually increases over portfolio volatility:

“Adding an Alpha-providing investment to a well-diversified Core portfolio will likely increase the standard deviation of the entire portfolio, as a tradeoff for higher overall returns. However, the addition of Alpha investments to the MPC-engineered Core portfolio may actually reduce the portfolio’s overall Beta, or sensitivity to market fluctuations. Because returns generated through an Alpha strategy do not necessarily move in lockstep with the broad market’s returns, the Beta of the Alpha portion may in fact be less than 1.0 – which would reduce the Beta of the combined portfolio.”

If the “alpha portion” actually has a low correlation to the core (and a similar volatility), we’re not sure how it would “likely increase the standard deviation of the entire portfolio”.  Unless, of course, the “alpha portion” is really just an “alpha-providing” investment - not a pure alpha investment.  This underscores the fact that when Janus says “alpha” it really just means “active”. 

While most investors measure absolute fee levels, kudos go out to Janus for evaluating fees in the context of alpha generation (see posting on this topic):

“…expenses are generally not critical to the evaluation of an Alpha manager or product. Management fees can be considered the “price” paid for the Alpha the manager generates – one can measure the “value” by comparing the absolute amount of Alpha generated to the price, or the fees charged by the product.”

Underscoring how efficient markets really are, Janus uses a t-statistic to determine the reliability of each manager’s alpha.  Unfortunately, a sample of 239 enhanced-index managers turns up only one that actualy produces reliable alpha.  Continues the paper:

“Meanwhile, 238 fell into a statistical no-man’s land – and 36 of those managers had t-Statistics poor enough to place them in the reliably unskilled position.”

The “Alternatives” Portion

This appears to be where the alpha is really generated.  The qualification criteria for an “alternative” is: a market correlation and beta of less that 0.6 and a volatility less than the market.  They provide some examples:

This is where the benefits of diversification actually reside (not in the misnamed “alpha portion”) and where Janus suggests it is taking a queue from Ivy League endowments.

“In taking an opportunistic approach to deploying Alternatives, more aggressive investments such as real estate or macro hedge funds will increase the return potential of a portfolio, while still realizing the benefits of diversification and decreasing risk for the overall portfolio.”

The Tactical Portion 

Finally, Janus recommends a module containing cash, treasuries and ETFs to a) address liquidity considerations and b) to capitalize on short term market trends.  Naturally, active market timing like this will lead to some sort of alpha.      

Our Conclusion: A Step in the Right Direction 

So to summarize, Janus’s Modular Portfolio Construction involves:

  • Core: beta
  • Alpha: some alpha, mostly beta
  • Alternative: mostly alpha, some beta
  • Tactical: alpha or beta      

It’s not a pure alpha/beta portfolio constriction approach since it relies on the familiar asset classes of traditional investing.  But it’s a great step in the right direction and is arguably more pragmatic that the idealized approach we often espouse on this blog.  Only time will tell if this “new beginning” will become immortalized in the Pantheon of investment techniques.