Q&A with Peter Bernstein

Posted on Marketwatch.com.

• MarketWatch: Has the fact that people know so much more about how markets work made investing any less risky?
  
  
  Bernstein: The central role of risk, if anything, has grown rather than diminished. We really can't manage returns because we don't know what they're going to be. The only way we can play the game is to decide what kinds of risk we're going to take. Risk is the beginning. The return above a benchmark -- "alpha" -- is how you measure whether you've outperformed. Alpha is what you're trying to get, but risk is the road you have to travel to get there.
  
  
  Q. What advances are helping investors capture above-average returns?
  
  
  A. With new active strategies, the big event is what they call "portable alpha." It didn't really develop until recently. Alpha means outperforming the market after adjusting for risk. That's what "beating the market" means. Meanwhile, "beta" measures what the market itself is doing. Beta risk, the risk of being in the markets, is the risk you can't avoid if you're going to be an investor. That's a matter of choosing which kinds of markets you want to be in -- stocks, bonds, cash, international, real estate. Those are basic decisions to make before you even begin. Then you say these are markets I want to be in, but I would like to earn a return greater than I expect I can get from simply being in the market, from being a passive investor.
  
  
  The interesting thing that developed from putting the question that way is these are separate decisions. Where you seek to outperform the market -- to get alpha -- and how to have your basic allocation of assets are completely separate decisions. Portable alpha means that you find ways to achieve alpha that are completely separate from the way you manage the basic portfolio. You're looking for alpha wherever you can find a manager who can beat a benchmark. It doesn't have to be in an asset class that you hold; it can be anywhere.
  
  
  Q. "Portable alpha" is a sophisticated institutional strategy, but is this innovation also finding a place in retail investors' portfolios?
  
  
  A. These are not simple strategies to execute. Let's say you don't want to be in international markets, but you know of a manager who can beat the index regularly. You'd like to get that extra return, so you have to fund that manager without disturbing your basic asset allocation. So one way or the other, these strategies involve leverage or derivatives, and sometimes both.
  
  
  For individual investors, Pimco, one of the biggest managers in fixed-income securities, has a mutual fund called StocksPlus plus an alpha.
  
  
  Money comes into the fund, and the fund buys futures on the S&P 500. It doesn't buy the S&P 500. For futures you only have to put up about10% cash, and the balance is invested in the bond market where it earns an alpha. That additional return is added to the return of the S&P. So StocksPlus is really only holding about 10% of its money in stocks and 90% in bonds. The 10% in stocks is S&P futures, so you're going to get the S&P return, but it's using the rest to try to get an edge -- alpha -- out of the bond market.
  
  
  Q. Early financial theories laid the foundation for modern Wall Street. Are they still relevant?
  
  
  A. Theories established a jumping-off point. But the assumptions were rigid and far from reality. Markets don't respond the way the theories describe, yet you can't understand the markets without this stuff.
  
  
  Think of the level of discussion about portfolio management before 1952, when Harry Markowitz said you have to think about risk as well as return. There was some sophisticated sense about asset selection, but in terms of the role of risk and risk management of the portfolio -- the whole collection of assets you own -- there was nothing. It was a great leap forward.
  
  
  Today, these ideas are alive and well. You take these highly sophisticated people in the business, like Barclays Global Investors, Goldman Sachs or the Yale endowment fund, and all start from these early ideas and go from there into elaborate forms of active management. David Swenson at Yale said it the best: It was out of his deep respect for the efficiency of the markets that he went away from conventional financial assets like stocks and bonds into hedge funds and real assets where markets were much less efficient.
  
  
  There are two things that make financial markets function. Financial markets are a bet on the future, so in their gut they're risk-taking. The other is that financial markets can't function without information. When you put these two together, you're making a bet on an unknown future but you're basing that bet on information. The theories follow from these two important features. Markowitz said you have to think about risk as well as return, because you don't know what the outcome is going to be. You do that by diversification, trying to maximize the trade-off between risk and return. ( source of article )