Alpha-Beta-Separation: From Theory to Practice

Stefan Engstrm a

Richard Grttheim b

Peter Norman b

Christian Ragnartz b

May 26, 2008

Abstract
Asset management techniques are consistently evolving and there
has been an intense debate concerning alpha and beta and how to
separate the two. This article presents a new asset management
setup which originates from theory and that separates alpha and
beta. The setup has been applied at the Seventh Swedish National
Pension Fund and the article includes empirical evidence from
applying this asset management technique, known as alpha-betaseparation, for a Swedish equity mandate. The results from the new
management model show not only significant improvement in
portfolio performance, but also a more transparent and cost
efficient portfolio structure.

JEL Classifications: G11, G23

Key words: Pension Fund, Performance, Alpha, Beta

a
b

Agenta and Stockholm School of Economics

The Seventh Swedish National Pension Fund

Introduction
The global asset management industry is subject to fast growth, driven by the transition from
defined benefit (DB) to defined contribution (DC) schemes and an increasing need for
individuals to save for future pensions. This has increased competition among asset managers
and an intensified search for alpha. Alpha is scarce and many academic studies have found
that the average asset managers performance is below the benchmark, in line with charged
fees, see e.g. Gruber (1996). This poor performance refers to studies of mutual fund managers
as the literature has focused on evaluating performance for this category of managers due to
lack of data available for other asset managers. However, pioneering work by Bauer et al.
(2007) document significantly better performance for a rich sample of U.S. pension funds.
The average performance for pension funds seems to be closer, but still inferior, to the
benchmark. To some extent pension funds perform better than mutual funds due to lower
costs.

Passive management has consistently gained popularity as a consequence of realized poor

performance. Moreover, recent pressure from pension fund sponsors focusing on lowering
costs has further increased the demand for passive management. Despite the obvious
difficulties to find alpha, many investors still make significant efforts to do so and active
portfolio management is still by far the dominating strategy. Those who still believe in active
management consistently make efforts in developing their investment process and trying to
identify new sources of alpha. Anson (2005) presents new insights, suggesting that
institutional investors should identify alpha and beta drivers separately as opposed to the
traditional model where alpha is attached to beta. Furthermore, the traditional asset
management model implies that alpha budgets are misspent on efficient markets determined
by the strategic benchmark. The framework that Anson proposes involves extending the
strategic portfolio with sources of alpha that come from less efficient markets and finding
investment products for it, e.g. hedge funds and concentrated equity portfolios.

The big pension funds organize their asset management in many different ways. Some choose
to build an investment management function internally with extensive capabilities. Others
prefer extensive cooperation with a single asset manager which work in a similar way as an
internal function but can imply further benefits from scale. However, European pension funds
have to an increasing extent reorganized and hired external specialist managers in order to try

to enhance alpha opportunities. One of the Swedish national pension funds, the Seventh APfund (AP7), has to a significant extent adopted this way when organizing their investment
management function. Almost 90% of AP7s total assets, USD 14 billion, were managed
externally by the end of the year 2007. This has allowed the fund to organize a small and cost
efficient investment management team to operate the fund. Initially, the investment
management function was organized in line with the traditional model were active managers
were chosen for markets where the greatest alpha opportunities were present, i.e. markets with
a lower degree of efficiency such as Asia excluding Japan. In contrast, a passive strategy was
implemented to minimize costs for markets considered more efficient such as U.S. large Cap
Efforts to obtain alpha was also in line with the Anson (2005) framework extracted through
strategies outside the strategic allocation, e.g. hedge funds and private equity funds. However,
in 2005 it was decided that AP7s investment strategy should change in order to improve
alpha opportunities from traditional long only portfolios. This article extends previous
literature by uncovering the new investment management process implemented by AP7. The
article is organized as follows: The next section presents the alpha/beta framework. The
section is followed by a description of the Swedish public pension system and the Seventh
Swedish national pension fund in detail. Finally, empirical results of the alpha-beta separation
and conclusions are presented.

Alpha and Beta

Investors have used the alpha/beta framework to attribute portfolio returns and help articulate
investment objectives for several decades. This framework allows the investors to assess how
both market returns (beta) and attempts to add value (alpha) have contributed to returns. In
addition, alpha and beta give some information on future returns. Hence, the alpha and beta
framework is a useful analytical tool, but it can also evolve to a framework for portfolio
management.

A clear and separate alpha/beta framework for portfolio management has not been
implemented extensively. However, the move towards separate management of alpha and beta
has to some extent begun with the investments in hedge funds and other alternative or
absolute return approaches. Interestingly, different markets have reached different degree of
maturity in this sense and have prepared for an alpha/beta framework. For example, currency

and fixed income markets have a longer tradition of long/short (alpha) investing compared
with equity managers where long/short investing appear within hedge funds. Over time, we
expect investors to push active managers to adopt more transparent and cost efficient alphabeta-separation. It is a rather simple strategy, with few drawbacks for the asset owners. Beta
or market exposure in either equity or fixed income markets - can easily be captured by lowcost passive strategies. Attempts to add value can be achieved in the form of pure alpha
strategies where managers' positions reflect only relative valuation insights. For example, an
active manager specializing in stock selection might hold a collection of long and short
positions that reflect their valuation insights, but represent no net market exposure. Similarly,
active fixed income or tactical asset allocation managers would reflect their specific relative
valuation insights without generating persistent exposure to beta. These strategies are simple
to implement as limited cash is needed.

The alpha-beta-separation framework is associated with several benefits compared with

traditional long-only portfolio management. These benefits accrue to both investors and
investment managers and estimates indicate alpha potential to double, but also greater
diversification benefits and lower costs.

Advantages for investors

It is a well documented fact that finding managers that are truly skilled is a challenging and
difficult task. By separating portfolio management of alpha and beta, investors expand the
opportunity set of skilled managers beyond that which is determined by the strategic asset
allocation. Hence, investors are able to search for skilled managers wherever they exist, even
in asset classes outside the strategic allocation. This allows investors to optimize alpha
management where active risk is most rewarded.

Advantages for active managers

Traditional active portfolio management combines management of alpha and beta. This
imposes significant constraints on active managers by portfolio construction limits, such as
the long-only constraint, security and sector constraints, and turnover constraints. These
constraints prevent managers from fully translating management skill into excess return. In a
pure alpha setting, unnecessary constraints are removed and allow the full insight of active
managers to be reflected in portfolio positions. The main benefit is the extension of the

investment universe, allowing for short positions, which create more investment
opportunities, see e.g. Grinold and Kahn (2000) that examine these implications.

Diversification benefits
Traditional active portfolio management is typically associated with analysis of a limited
number of securities. This prevents active managers from realizing the full diversification
benefits. Hence, passive or beta management typically allow for improved diversification
benefits as more securities are included in the portfolio management.

Transparent fees
Transparency is an important condition for any market to work efficiently. Separate
management of alpha and beta provides this transparency in managers' fees for management
of alpha and beta. Expensive alpha can be blended with cheap beta in line with budget
constraints from plan sponsors and opportunities to add value. In this sense, separate
management of alpha and beta lets investors capture the full economies of beta management
and pay active management fees that reflect a manager's skill and ability to add value.

Lower costs
Traditional long only mandates impose unneccesary constraints also when it comes to
terminating old managers and hiring new ones. This transition is associated with substantial
costs which reduces the efficiency in the market substantially. In order to minimize the
efficiency loss, separate transition managers are hired to execute this challenging task.
However, even though these managers are in place, AP7 have experienced transition costs of
100 basis points for transition of long only mandates. The new alpha concept implies
significantly lower transition costs not exceeding 5 basis points.

The Swedish Public Pension System

The Swedish government has six pension funds that manage assets for the public pension
system. Five funds, the First, the Second, the Third, the Fourth and the Sixth AP-fund support
the defined benefit system and the Seventh AP-fund supports the defined contribution system,
the so called premium pension system. The Seventh AP-fund manages the default fund in the
DC-system, which comprises almost one third of total assets in the system. The public
pension funds managed in total USD 190 billion at the end of 2007. The investment portfolios

consisted of 59% equity holdings, 35% fixed income holdings and 6% alternative
investments. Almost a quarter of the equity holdings (27%, or 16% of the total portfolio) were
invested in Swedish equities whereas the main part of the fixed-income portfolio has been
invested in Swedish holdings. Table 1 presents assets under management and net flows in the
Swedish public pension system. The table shows that the public pension system has grown
significantly since 2001 and in particular the defined contribution system. The defined
contribution system is expected to continue to grow in a steady phase and estimates suggest
that it will reach about SEK 2000 billion before 2030 (the price of one USD in 2007 was SEK
6.5).

Table 1. The Swedish public pension system

2001

2002

2003

2004

2005

2006

2007

AUM

545

480

570

640

765

854

898

Net flow

18

20

10

12

AUM

65

59

94

125

192

267

308

Net Flow

18

20

21

22

23

49

28

AUM

20

19

31

41

60

81

90

Net flow

14

AP1-4 & 6

PPM

AP7

Total Public Pension

AUM

610

539

664

765

957

1 121

1 206

Net Flow

36

40

31

29

35

56

36

The table shows assets under management (AUM) and net flows in the public pension system. All figures are in
SEK billion and the price of one USD was SEK 6.46 by the end of the year 2007. The five AP-funds, AP1-AP4
and AP6 are buffer funds for the defined benefit system. The PPM system is part of the defined contribution
system and the AP7 manages the default alternative in the PPM.

The Seventh Swedish National Pension Fund

The Seventh Swedish National Pension Fund (AP7) was set up in connection with the
introduction of Swedens reformed pension system and received the first inflows in
September 2000. The reformed system includes the entire workforce, but the previous pension
system is gradually being replaced. Older individuals will, depending on age, get a majority of
their pensions from the old system in contrast to the younger individuals that rely on the new
system. This has implied that 4.4 million individuals participated initially and by the end of
2006 participation had grown to 5.6 million individuals. The new pension system has two
major components: An income-determined PAYG part and a premium-determined part
(DC). 1 In this system the pension premiums paid are invested in mutual funds on behalf of the
individual savers. The balance on each savers account at retirement determines how much
pension he/she will receive, implying that the individual actually has to bear the market risk.
Each individual saver can choose to have their premiums invested in up to five funds out of
more than 700 private funds participating in the system today. The individual decision making
is similar to U.S. 401k plans but the investment menu in the Swedish system is significantly
more extensive than typical 401k plans. The Swedish pension system has one default fund,
the Premium Savings Fund. This fund which is supervised by AP7, manage the contributions
for those who have not chosen a private fund manager.

The initial investment structure of the AP7 was similar to many other pension funds where
AP7 serves as a manager of manager, i.e. on an ongoing basis hiring, monitoring, and firing
managers with limited security selection internally. By the end of 2007, almost 90% of total
assets were managed by external managers. The internally managed assets include fixed
income, Swedish equities and some of the private equity holdings. All other asset classes were
managed externally by 16 different managers. Table 2 presents AP7s strategic asset allocation
during 2000 to 2007 and shows a high allocation to equities. The allocation is revised every
third year. At all times, the allocation to equities has exceeded 80% of the total portfolio.

Engstrm and Westerberg (2003) provide in the first examination of the pension system additional details of
the initial set up. Engstrm (2007) provides details on the general development of the system and individuals
investment decisions.

Table 2. The AP7 strategic asset allocation 2000-2007

Asset class
Swedish equity
Global equity
Emerging market equity
Swedish fixed-income
Foreign fixed-income
Alternative investments

2000

2004

2007

25
65
0
10
0
0

17
65
0
10
0
8

20
52
10
4
4
10

The table shows the strategic asset allocation in per cent of total portfolio for the Seventh AP-fund for the years
2000, 2004 and 2007. The strategic asset allocation is revised every third year

Alpha/Beta implementation at AP7

After the first five years of business, the board at AP7 decided to make a change to the
investment policy to allow for an alpha-beta separation in the management of the funds assets.
This decision originated from the experience of poor performance where the AP7s external
managers performed inferior to or in line with the benchmark, similar to the average U.S.
pension fund, see for example Bauer et al (2007). The decision was a natural development for
AP7, given the advantages outlined above, and the fact that strategies for alpha and beta
already was in place. The strategic asset allocation process defines the market/beta exposure
and alpha opportunities were reviewed in the investment management process. Hence, the
main change was a complete specialization approach in the daily investment operation. Beta
specialists were already in place and the new regime focused on finding pure alpha specialists
as well. This true specialisation approach for manager selection was supposed to add value, in
addition to improving the overall cost effectiveness, by additional pressure on alpha managers
without any net capital under management implying better average performance.

The transition from traditional portfolio management to alpha-beta-separation started in late

2005. It was decided that the process of transforming the portfolio management structure into
an alpha beta framework should first be implemented with the internal equity team that
managed domestic equities. The first practical problem was how to define the investment
guidelines including risk budgeting and monitoring.

Risk limits and targets for traditional active managers trying to create alpha are typically
defined in terms of tracking error. This is not appropriate for an alpha manager. The
benchmark for a pure alpha mandate is simply zero and hence the tracking error is reduced to
the standard deviation of returns. The standard deviation of alpha return is hardly the ultimate
risk limit. Instead a risk budget was defined by using expected tracking error, the return target
and the notional amount. The purpose of the risk budget is to cover potential losses and is not
capital to be used for active bets in the day to day operations. In addition to the general risk
budget, constraints on short selling and VaR are implemented in the day-to-day risk
management.

The return target in the new setup is similar to the target for previous active managers, that is,
one per cent above benchmark return. For the alpha manager, with zero as benchmark, this
translates into a performance of one per cent of the notional amount. Moreover, futures are
used in order to earn the market return (beta) on the capital for the risk budget. This ensures
that the strategic allocation is not negatively effected by the alpha mandate. The risk budget is
determined by dividing the notional amount by the target information ratio. Moreover, the
investment guidelines allow alpha mangers to take short term beta bets, given the constraint of
zero net holding. However, the beta should over a longer horizon be close to zero as well.

An important lesson from the first internal alpha mandate was that the different set up had
implications on the investment process and the skill set of managers that were to be hired.
This knowledge was considered when evaluating external managers including the current
external active Swedish equity manager. Figure 2 and 3 present monthly return analysis of the
active managers performance from June 2001 through April 2007. The size of this mandate
varied significantly over time but was on average SEK 800 million.

Figure 2: Portfolio return vs market

Figure 3: Monthly excess return

20%

2.0%

15%

1.5%

10%

1.0%

5%

0.5%

0%
-20%

-10%

-5%

0.0%
0%

10%

20%

-10%
-15%
-20%

-0.5%
-1.0%
-1.5%
Jul-01

Dec-02

Apr-04

Sep-05

Jan-07

The figure shows the relation between return of the

The figure shows the return of the external active

external active managed Swedish equity portfolio and the

managed Swedish equity portfolio in excess of the

benchmark benchmark return.

return.

Figure 2 shows a linear relation between benchmark return and portfolio return for the active
manager. Hence, the manager has not successfully implemented market timing in terms of
increasing and lowering risk at appropriate market conditions. The intercept shows an annual
alpha of -0.4% which is slightly better than the benchmark relative annual return of -0.6%
which can be explained by a beta that is just below 1. This implies an inferior performance in
excess of 5% over the six year period that the manager was hired. As can be noted from
Figure 3, the poor performance was not due to a single event. Instead continuous, but random,
under performance was obtained. The manager was certainly active with at best 2% daily
returns above the benchmark and at worst 1.3% below the benchmark. Interestingly, the
monthly deviations from the benchmark are of the same magnitude as the daily observations.
This performance was not satisfactory and the evaluation of the manager did not show any
alpha capabilities. The manager was fired and the monies transferred into the alpha-betaseparation framework.

The beta part of the separation framework is simple as these providers have been around for
long. One of the established firms has been hired for part of the Swedish equity portfolio since
early 2001. This has given the AP7 a low cost beta exposure that despite initial difficulties to
mimic the benchmark meets the performance expectations. Figure 4 and 5 present monthly
return analysis of the beta managers performance from June 2001 through December 2007.
The assets under management for the mandate have varied between SEK 1 billion and SEK
17 billion.

Figure 4: Portfolio return vs market

Figure 5: Monthly excess return

20.00%

1.00%

15.00%
0.50%
10.00%
0.00%

5.00%

-20.00%

-10.00%

0.00%
0.00%
-5.00%

10.00%

20.00%

-10.00%
-15.00%
-20.00%

-0.50%
-1.00%
-1.50%
Jun-01 Aug-02 Sep-03 Oct-04 Nov-05 Dec-06 Jan-08

The figure shows the relation between return of the

The figure shows the return of the passive managed

passive managed Swedish equity portfolio and

Swedish equity portfolio in excess of the benchmark

the benchmark return.

return.

Figure 4 shows an almost perfect relation between beta portfolio return and the benchmark.
However, producing 100% beta is subject to challenges as replicating all the market
constituents are difficult. In Figure 5, we note that volatile market conditions gave rise to
large deviations for the beta portfolio relative the benchmark but over time these even out.
The performance of the beta portfolio was over the six year time period on average -0.1% per
year relative the benchmark which refers to implementation costs. The beta exposure obtained
was one.

Hiring of alpha managers has proved to be difficult. First, identifying a manager with alpha
capabilities among traditional managers is a difficult task. However, when potential alpha
managers were identified, the new alpha concept, without net capital, proved difficult to
communicate and to gain approval. Apart from trivial discussions concerning how they should
price such a mandate, potential managers have not easily adopted a way of reasoning based on
the notional amount, even though the parallel with a traditional long only mandate is obvious.

Figure 6 and 7 presents an analysis of the daily returns for the first alpha manager hired by the
AP7. The data refers to the period May 2007 through December 2007. The risk budget for the
mandate has been constant at SEK 2 billion.

10

Figure 6: Portfolio return vs market

-4%

-3%

-2%

-1%

Figure 7: Portfolio return vs market

6

-2

-2

-4

-4

-6
0%

-6
0%

1%

2%

3%

4%

The figure shows the relation between return of the

The figure shows the relation between the return

alpha mandate and corresponding passive benchmark

of the alpha mandate and the corresponding passive

return when negative market returns are present.

benchmark return when positive market returns are

present.

Figure 6 and 7 show no relation between alpha mandate returns and the return of the passive
(beta) benchmark. Interestingly, the estimated slope coefficient for the alpha mandate
indicates a negative beta when negative market returns are present and a positive beta when
positive market returns are present. This implies that the manager seems to have some market
timing ability in addition to good security selection ability. However, the beta is neither
statistically significant different from zero in both bull and bear market. Overall, the return for
the first eight months has implied a profit of 29 million, which corresponds to a 2.2% annual
out performance. This is far above the target out performance of 1%. The daily returns vary
between -0.2% and 0.27% of the risk budget with an average gain of 1 basis point per day.

Conclusions
Several lessons have been learnt after little more than two years of gradual transition from
traditional portfolio management into an alpha-beta-separation framework at the Seventh
Swedish national pension fund. One important lesson is that the asset management industry
has not been fully prepared to meet the new demand of separate management of alpha and
beta as opposed to traditional active portfolio management. This has implied many difficulties
to identify and to hire alpha managers as these sit in traditional active asset management
boutiques. The difficulties include reluctance from managers to get additional pressure as
performance in dollar terms are more pronounced but also of agreeing on a management fee

11

as no capital is under management and pricing used to be in relation to asset under

management. However, the market seems to adopt this new asset management framework and
asset managers are increasingly interested in providing services. The management fees
typically end up being a blend of traditional active management structure and the more
performance related fee similar to the one found for alternative asset classes. Hence, this
implies that alpha managers are more expensive than traditional active managers due to higher
performance fee but cheaper than alternative asset classes due to a lower fixed fee. This
implies that alpha managers to some extent intermediate hedge fund managers as alpha now
can be obtained at lower cost. As a consequence, AP7 reduced its exposure to alternative
investments in 2007 and is instead trying to obtain alpha trough alpha managers. Another
important lesson of the alpha-beta-separation framework is the overall improvement in
portfolio performance. Traditional active managers that were hired struggled to deliver alpha
and AP7 as a whole did not obtain a positive alpha. The new setup has implied a cost efficient
beta exposure and a positive and significant alpha.

References
Anson, M, Institutional Portfolio Management: The mission and the mandate, Journal of
Portfolio Management, Summer 2005, pp 33-43
Bauer, R, Frehen, R, Lum, H, and Otten, R, The Performance of U.S. Pension Funds: New
Insights into the Agency Cost Debate, Working Paper, Maastricht University, 2007
Engstrm, S and Westerberg, A, Which Individuals Make Active Investment Decisions in
the New Swedish Pension System Journal of Pension Economics and Finance, 2007, vol
2, pp 225-245
Engstrm, S, Preferences and Characteristics of Mutual Fund Investors, Working Paper,
Stockholm School of Economics, 2007
Grinold, R. and Kahn, R., The Efficiency Gains of Long-Short Investing, Financial Analyst
Journal, 2000, vol. 56, no 6 pp .
Gruber, M., Another Puzzle: The growth in actively managed mutual funds, Journal of
Finance, Vol. 51, pp 783-807, (2007)
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