Portable alpha
28 August 2006

In this article we look at the strategy of using portable alpha and the opportunity that it creates for including non-traditional investments, like hedge funds, into a fund’s asset allocation.

We’ll first look at the concept of alpha and beta and describe why portable alpha was developed. Next we explain portable alpha via a simple example and discuss the types of managers that can be used with this strategy.

What is Beta?
Beta measures the risk of a portfolio relative to an efficient market and can be interpreted as the sensitivity of a portfolio’s expected excess return to the efficient market’s expected excess return. If the market is inefficient, the beta of the portfolio is a less accurate predictor of a portfolio’s excess return. For example, if a portfolio has a beta of 0.5 in an efficient market, a 1% rise in the market’s excess return should cause the portfolio’s excess return to rise by approximately 0.5%.

Below we show the expected return of portfolios with various betas in an efficient market. In this example, we expect the market to return 10% above an assumed risk-free rate of 5%. We can see that as the beta of a portfolio increases, the expected return also increases.

What is Alpha?

The difference between a portfolio’s realised return and the expected return calculated from its beta is known as alpha. Generally, higher alpha is generated in inefficient markets and lower alpha is generated in efficient markets. The graph below shows the alpha generated by a portfolio with a beta of  0.5. The portfolio’s expected return was 10%, whereas the realised return was 12.5%, giving an alpha of 2.5%.

Portable Alpha

Portable alpha is a strategy that allows the investor to separate the alpha and beta portions of the return. By separating these, the best active managers can be selected solely on their ability to generate alpha while the beta portion can be obtained at lower management cost.

A portable alpha strategy is generally used in cases where the investor believes that traditional strategies would be unable to deliver satisfactory alpha and where the alpha, after performance fees and structuring costs, would be significantly higher if an alternative strategy is used. It would also be used in cases where the investor doesn’t want to pay performance fees for beta returns.

We now look at an idealistic example of how we can transport alpha from a traditional equity portfolio to a bond portfolio. The components of the equity portfolio’s return are shown below and consist of a risk-free, a beta and an alpha portion. To employ a portable alpha strategy, we first need to eliminate the beta portion of the portfolio’s return by using equity index futures and this is shown in the first step. We are then left with the alpha of the portfolio and the risk-free rate. In the second step, we use bond futures to gain exposure to the bond market resulting in a portfolio with alpha transported from equity returns, beta from bond returns as well as the risk-free rate.

Portable alpha strategies are not limited to more traditional portfolios, but can be successfully employed with hedge fund portfolios. As an example, the return components of a market-neutral hedge fund consist of an alpha and a risk-free portion. To transport this hedge fund’s alpha to a bond portfolio, we follow step 2 as explained above. In this case, we will have a portfolio with alpha transported from the hedge fund, beta from bond returns as well as the risk-free rate.

The above example gives a rough indication of how portable alpha strategies can be implemented. However, in real-world cases implementation difficulties do exist. Some of these issues include the assumption of the portfolio having a constant beta, the availability of suitable derivatives to hedge the portfolio’s market exposure, the cost of the trading these derivative positions as well the tracking error between the derivative position and the portfolio. However, regardless of these issues, the strategy remains an attractive option for investors wanting to increase alpha without deviating from their strategic investment strategy.

ENDS
For more information:
Dianne Lea - Marketing Manager - (021) 683 111 or 083-650 0027