Portable alpha is a strategy in which investors separate the returns they get from overall market performance and the returns they get from stock picking. It allows them to generate these returns, which are lumped together in traditional investing, from different asset classes. This allows for more finely tuned risk management capabilities and simpler assessment of the performance of a portfolio.
Alpha and beta are terms for the different types of returns an investor can receive from stocks. When a stock price goes up, that rise has two components. One is the performance of the asset class as a whole, which is called beta. The other is a measure of the stock’s performance relative to the other assets in its class: alpha. Alpha is an important measurement of success; if you make 5 percent returns on general market investments, your portfolio is good if the market rose by only 2 percent, but it is bad if the market rose by 15 percent.
Traditional investment strategies generate alpha and beta from the same holdings. It is difficult to calculate a fund’s performance relative to the market because the choice of benchmarks greatly influences alpha. Also, if the investor wants to have relatively more or less exposure to alpha or beta risk or returns, it requires a restructuring of his portfolio.
In portable alpha, the investor has one part of the portfolio that generates beta returns, which come from actively timing the market or passively waiting for a market increase based on historical trends. This can consist, for example, of index futures. Another part of the portfolio is dedicated to outperforming the market. The manager combines stock investment with derivative investment to eliminate market risk, and thus beta returns, leaving pure alpha risk and returns in that section of the portfolio.
Creating a pure alpha investment requires complex trading strategies and access to a variety of equity and derivatives markets. The lack of regulation of hedge funds has put them at the forefront of portable alpha trading because their managers have the necessary tools to create pure alpha investment strategies. This also, however, limits portable alpha to those investors with sufficient net worth to invest in hedge funds.
The strategy is called portable alpha because the pure alpha section of the portfolio is separable from the beta section. This means that an investor can leave his original portfolio untouched and add on a pure alpha section, which is known as an overlay. Often, portable alpha investors switch their beta investments over to leveraged trading, using the money that is left over to invest in pure alpha. That way, they generate additional returns with no further cash outlay.
Some investors favor portable alpha because it allows them to maintain their asset allocations while adjusting the amount of risk to which they are exposed. It also increases the portfolio’s diversification because alpha and beta are not correlated, so a loss in one area may be canceled out by a profit in the other. The strategy, however, does not always work out in practice the way that it does in theory. Pure alpha investments are often correlated other asset classes despite their theoretical independence, which can interfere with the portable alpha strategy and cause unexpected losses.