Portable alpha

Portable alpha is the transfer of alpha from one portfolio to another. It is a process that requires hedging the beta of the portfolio from which alpha is being transfered, and also adjusting the portfolio to which alpha is transfered to maintain its beta. It is commonly a part of enhanced indexing and similar strategies.

Portable alpha example

A pension fund has diversified investments. This includes a conservatively run UK portfolio has a beta of 1.0 (relative to the FTSE 100).

Fund managers want to invest more aggressively to increase returns, but the trustees will not agree to high beta strategies.

The solution chosen is:

  1. Sell part of the UK portfolio, in order to fund more aggressive investments
  2. This leaves the UK portfolio with a beta of less than one. This will depress returns in a rising market. So part of the money raised (from selling)are used to enter into FTSE 100 index futures to return the beta to 1.0.
  3. The bulk of the remainder us invested in an existing external actively managed small cap fund
  4. This fund has a high beta. The rest of the money is used to buy enter into more index futures on the FTSE small cap index. This hedges the beta of the active fund

The end result is that the alpha of the actively managed portfolio is added to the returns of the pension fund’s UK equities portfolio without affecting its beta.

Money is needed to enter into futures contracts, because margin is needed to cover the possibility of a liability

Uses of portable alpha

Portable alpha is attractive for the same reasons that hedge funds are: it is a source of alpha that is uncorrelated with the markets. It offers a broad range of alpha only investments, including traditional long only active management.

Hedge funds’ returns tend to be high correlated with those of other hedge funds following the same basic strategies (despite the proprietary variations employed). This reduces the diversification they offer. There are many other alternative investments available but all that have any beta need the alpha to be made portable to be used in this way.

Criticisms of portable alpha

The key problem with portable alpha is that, although it limits beta, the added alpha comes with added volatility. In other words, it does not really allow the addition of alpha without increasing risk. Instead, it exploits the weakness of beta as a risk measure to hide the additional risk.

Portable alpha ultimately delivers added returns at the risk of under-performing. This is not very different from traditional active management. It also added extra costs: in the example above, not only does the pension fund pay the active manager’s fees, but also absorbs the costs of the futures transactions needed to neutralise the effect on beta.

It is not clear that portable alpha benefits investors. It does allow investment managers to charge active management fees from clients who might otherwise opt for passive strategies.

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