Portable Alpha
Encyclopedia
Portable alpha is the return of an investment portfolio with zero market risk
(beta). Being independent of both the direction and the magnitude of the market's movements, it represents the manager's skill in selecting investments. Elimination of the market risk can be accomplished by means of short selling
and derivatives such as futures
, swaps, and options
.
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
, 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.
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.
Market risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
(beta). Being independent of both the direction and the magnitude of the market's movements, it represents the manager's skill in selecting investments. Elimination of the market risk can be accomplished by means of short selling
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
and derivatives such as futures
Futures
-Finance:*Futures contract, a tradable financial contract*Futures exchange, a financial market where futures contracts are traded*Futures , an American finance magazine-Music:*Futures , a 2004 release by Jimmy Eat World...
, swaps, and options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
.
See Alpha
Alpha (investment)
Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers' performances...
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
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
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 stocksStocks
Stocks are devices used in the medieval and colonial American times as a form of physical punishment involving public humiliation. The stocks partially immobilized its victims and they were often exposed in a public place such as the site of a market to the scorn of those who passed by...
, 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
Russell 2000
The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index.The Russell 2000 is by far the most common benchmarkfor mutual funds that identify themselves as "small-cap",...
) 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
Alpha
Alpha is the first letter of the Greek alphabet. Alpha or ALPHA may also refer to:-Science:*Alpha , the highest ranking individuals in a community of social animals...
. 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 LeverageLeverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
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
Investment policy
An investment policy is any government regulation or law that encourages or discourages foreign investment in the local economy, e.g. currency exchange limits.- Explanation :...
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
Beta coefficient
In finance, the Beta of a stock or portfolio is a number describing the relation of its returns with those of the financial market as a whole.An asset has a Beta of zero if its returns change independently of changes in the market's returns...
returns; the second is long/short and market neutral, yielding alpha
Alpha (investment)
Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers' performances...
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
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
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.