Positive Alpha Generation

Positive Alpha GenerationSuccessful investing is about generating ideas on the future of financial markets. But it is also about implementing these ideas in portfolios, managing risk, and satisfying investor needs. Dr. Diderich presents tools and techniques to develop investment processes to allow the successful transfer of investment ideas into real performance, that is, positive alpha. The book explains the underlying theoretical concepts and describes how they can be applied in practice. A key focus is put on illustrative real world examples.

Dr. Diderich uses the value chain concept as guiding principle to explain the different value-adding stages of an investment process. The book covers process as well as organization aspects related to generating positive alpha. It focuses on different quantitative and qualitative techniques for forecasting markets and taking investment decisions. The author devotes three chapters to risk management. Portfolio construction algorithms, ranging from the classical Markowitz model to advanced risk budgeting as well as factor model-based approaches, are reviewed and their usage illustrated. A special focus is put on practical implementation aspects, like handing transaction costs and using derivative instruments. As an investment product is only as good as the needs it satisfies, Dr. Diderich presents and compares different investment processes for different types of products ranging from benchmark-oriented portfolios, absolute positive return solutions, capital protection approaches, hedge funds, to liability-driven investing methods. Quality control is related to performance measurement models.

This book shows how an investment manager can provide investment solutions that maximize his or her opportunities along the four dimensions, delivering promised performance, being flexible as well as cost efficient, offering transparency, and providing innovation in order to best satisfy the investor’s needs. At the end of the book the reader will be capable of designing or enhancing an investment process for a single or a family of investment products and portfolios from start to finish. The book will be of interest to portfolio managers, investment product designers, quantitative analysts and anyone involved in investment design processes.

The foundation for creating sound investment solutions has been laid out when Markowitz introduced in 1952 the concept of modern portfolio theory in his seminal paper called Portfolio Selection. The full significance of the relationship between return and risk, and with it, the effects of diversification, was articulated. In the following years numerous models of financial markets, like the capital asset pricing model or the arbitrage pricing theory, have been developed. A large number of theoretical as well as practical toolboxes have been introduced that directly or indirectly allow enhancing the quality of investment solutions.

But few has been written on combining these investment models into successfully investment products and especially customized solutions. In this book I take an engineering approach to portfolio management. I present the different models and toolboxes that have been developed in the past and compare their strengths and weaknesses. I especially focus on the process of combining them in order to build sound investment processes. Both modeling as well as organizational aspects are addressed.

Successful investment managers differentiate themselves along four key dimensions, that is,

  • they deliver the promised performance, whether relative to a benchmark or absolute,
  • they implement an investment process that is cost efficient in production, but flexible enough to satisfy the specificities of the investor’s needs,
  • they offer a transparent and trustworthy investment management approach, and
  • they provide innovation in order to understand and best satisfy the investor’s needs.

This book is about showing how an investment manager can provide investment solutions that maximize his opportunities along these four dimensions. Delivering the promised investment performance is essentially driven by the investment manager’s forecasting skills. I describe techniques that can be used to develop these skills in a consistent manner and combine them to leverage their impact. I strongly believe that cost will become an even more important differentiating factor in the future, especially with the introduction of new pricing models. A very promising approach to achieve cost efficiency, especially when dealing with a large client base, is the value chain approach or a variation of it, like value nets. The different constituents of an investment process, called modules, are presented throughout this book based on the value chain approach. From an investor’s perspective, buying an investment solution or entering into a contractual agreement with an investment manager, is accepting a promise into the future. Especially when the investor is not the actual owner of the funds, but only its trustee, it becomes very important that the proposed investment solution is transparent to a degree that the investor is capable and willing to trust it. This can be achieve though three elements, that is, a structured investment process that can easily communicated and understood, a clear definition of roles and responsibilities, and a quality or performance management approach. Finally innovation can only be achieved if the investor’s needs are well understood and translated into investment solutions that can be produced with the available skills.

I describe in this book numerous techniques to achieve investment management success. They are based on the experience of colleagues and me through designing and implementing numerous investment processes. But they are only examples and should be considered as such. It is the role of each investment manager to combine and adapt the proposed techniques so that they fit with his individual needs and are based on his specific skills. My goal with this book is achieved if I have provided the reader with ideas that he has not yet thought of or has though of from a different perspective and that he believes could be relevant, or at least interesting, to adapt and implement in his own environment.

CHAPTER 1 – Introduction

PART ONE – The Value Chain of Active Investment Management

CHAPTER 2 – Key Success Factors for Generating Positive Alpha

CHAPTER 3 – The Investment Management Value Chain

PART TWO – Forecasting Markets

CHAPTER 4 – Judgmental Approaches for Forecasting Markets

CHAPTER 5 – Quantitative Approaches for Forecasting Markets

CHAPTER 6 – Taking Investment Decisions

PART THREE – Risk Measurement and Management

CHAPTER 7 – Modeling Risk

CHAPTER 8 – Volatility as Risk Measure

CHAPTER 9 – Alternative Risk Measures

PART FOUR – Portfolio Construction

CHAPTER 10 – Single Period Mean-Variance based Portfolio Construction

CHAPTER 11 – Single Period Factor Model based Portfolio Construction

CHAPTER 12 – Dynamic Portfolio Construction

PART FIVE – Portfolio Implementation

CHAPTER 13 – Transaction Costs, Liquidity, and Trading

CHAPTER 14 – Using Derivatives

PART SIX – Investment Products and Solutions

CHAPTER 15 – Benchmark Oriented Solutions

CHAPTER 16 – Absolute Positive Return Solutions

CHAPTER 17 – Capital Protection and Preservation Approaches

CHAPTER 18 – Hedge Funds

CHAPTER 19 – Liability Driven Investing

PART SEVEN – Quality Management

CHAPTER 20 – Investment Performance Measurement

“This timely book offers a comprehensive framework of best practice models and processes that will help active investment managers sharpen their focus on the four key dimensions of understanding investor needs; delivering the promised performance; maintaining absolute transparency and trustworthiness; and ensuring cost efficiency. Reading Dr. Diderich’s systematic treatment of the subject against the backdrop of the credit crisis, one gets the strong inkling that if more investment managers the world over had relied on the kind of rigorous and disciplined techniques presented by the author, many egregious investment mistakes, and many fateful instances of confusion between luck and skill, would have been avoided”
JEAN-FRANÇOIS RISCHARD, international consultant, author and former Vice-President for the World Bank
“An invaluable tool and a reference book for any serious investment professional, Positive Alpha Generation provides the reader with a sound grasp of both traditional and cutting edge portfolio construction techniques. The author balances theoretical concepts and practical applications to pave the way to a successful positive alpha quest”
YANNICK DANIEL, Head of Société Générale Index, SGCIB, Paris
“Dr Diderich has written an important book on the practice of generating skill-based investment returns. With admirable clarity, he combines financial models and techniques with managerial insights. The result is an impressive treatise on how investment processes can be structured successfully. This book should prove to be of considerable value to practitioners in the investment and hedge fund industries alike”
CHRISTIAN C. P. WOLFF, Director, Luxembourg School of Finance, University of Luxembourg
“The turmoil of the current financial crises highlights how difficult and delicate it is to establish and follow sound investment processes. Based on a solid and fine analysis, the study presented by Dr. Diderich offers a precious contribution for a better understanding of expected performances and actual risks and provides a deep insight into the shaping of best possible practices for a conscious and intelligent monitoring of investment portfolios”
ANDRÉ PRÜM, Dean of the Faculty of Law, Economics and Finance, University of Luxembourg