Portable alpha

Portable alpha

Portable alpha is an investment management term which refers to the return of an investment manager who has intentionally and completely eliminated his market risk, or beta. The return of such a portfolio will only represent the manager's skill in selecting investments within the market, and will be independent of the direction or magnitude of the market's movement. The elimination of market risk can be accomplished through use of futures, swaps, options, or short selling.

See Alpha for a definition of alpha.

Here, "Portable Alpha" implies that the extra returns (alpha) can be separated from the changes of the market by hedging the market exposure of the portfolio.

The process of "Portable Alpha" is also sometimes referred to as "Alpha Transport"

Example of Portable Alpha

As an example, consider a manager who invests only in small-cap US stocks, and the stocks in his portfolio have an average beta of 0.85. In a bear-market year, his portfolio returned 5% less than a risk-free asset, while the small-cap US stock market (the Russell 2000) declined 10% below the risk-free rate. Based on his beta (market risk), his portfolio should have returned 8.5% less than the risk free asset, but his skill in picking small-cap stocks resulted in his portfolio only declining 5% below the risk-free rate. The difference between 8.5% and 5% is attributed to skill and called alpha. So his alpha for this year would be 3.5%.

To make this 3.5% alpha "portable," the manager could have sold Russell 2000 index futures at the beginning of the year, hedging out his exposure to the market. An investor in this type of portfolio would experience a return, not of 5% less than that of the risk free asset, but a 3.5% above that of the risk free asset.

Usage of a Portable Alpha manager

Institutional investors typically make use of this type of investment management as an addition to their portfolio. They gain exposure to a portfolio of their desired markets through use of passive investments, and use Leverage against this portfolio to invest in the portable alpha manager. As long as the manager returns enough alpha to cover their costs of investing (interest and fees), the investor can port the excess return to his portfolio.

Because market risk is eliminated, an investor might be convinced to invest in asset classes that he may not otherwise wish to invest in, as long as the investor has confidence in the skill of the investment manager. For example, a hospital endowment's investment policy might prohibit investment in commodities, but the board might be convinced that they can circumvent this policy for a portable alpha manager who invests in commodities, because he hedges out his exposure to the commodities market.

Another method is via a so called 130/30 strategy. The idea is relatively simple: the manager shorts some fixed percentage of the portfolio (in this case, 30%), and uses the proceeds for further purchases. The purchase of additional assets with the full capital from the short sale is made possible by what is called an enhanced prime brokerage structure. This raises the long portion of the portfolio to 130% of the original investment capital. The net effect of this strategy is to separate the portfolio into two portions: the first portion is long only, yielding beta returns; the second is long/short and market neutral, yielding alpha returns. The strategy allows managers to bet against specific stocks they believe to be over-valued, rather than being restricted only to stocks they believe will increase in value (as is the case in a long-only portfolio). For example, investment bank Goldman Sachs Asset Management’s model global long-only portfolio invests in around 200 stocks; by comparison its Global Flex model portfolio (following a 130/30 strategy) invests in approximately 250 stocks and shorts about 100 – giving a total of some 350 names.

ources

* [http://www.investopedia.com/terms/p/portablealpha.asp Investopedia]
* [http://www.indexinvestor.com/Free/alphaBeta.php Index Investor Newsletter]
* [http://faculty.fuqua.duke.edu/~charvey/Teaching/BA453_2004/Polhlman_Portable_alpha.pdf Kung and Pohlman]
* [http://www.epn-magazine.com/news/fullstory.php/aid/2131/130_30:_going_short_is_the_way_to_gain_alpha.html 130/30: going short is the way to gain alpha]
* [http://www.hausarbeiten.de/faecher/vorschau/71970.html German diploma thesis about portable alpha]


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