Alpha Building Blocks

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Alpha can be generated through a number of different investment approaches, including active portfolio management, smart beta strategies and portable alpha techniques, among others.

Alpha is a financial measure of an investment’s excess return relative to a market benchmark, where a positive alpha means a fund has outperformed the market. Alpha strategies aim to capture the risk premium, or benchmark-beating returns, attached to underlying risk factors.

Beta exposure, which represents returns gained from market movements, can be obtained through tracking market-representative indices such as the S&P 500 Index. This low-cost passive investment strategy targets long-term gains from the equity market’s risk premium over safer government bonds, for example.

Active fund management, which has stock selection at its core, seeks to better the returns offered by the market as a whole. Portfolio managers charge investors fees for their ability to identify and take advantage of alpha sources.

Given the rise of cheaper, semi-passive alternatives, the active fund management industry has growing competition as the main supplier of alpha investment returns, placing the performance of managers in the spotlight.

Custom indices

Custom indices which target market inefficiencies in order to generate alpha returns are gaining in popularity partly because they carry lower fees. These alternatively-constructed indices are based on a set of predefined rules and do not follow the traditional size-based weighting model of benchmark indices.

Otherwise known as smart beta or self-indexing, these indices represent an active twist on usual passive index tracking. Some smart beta strategies aim primarily to closely track the market while managing risk, though others aim for superior investment returns.

For example, value and momentum strategies strive for market-beating returns, while low volatility and equal risk contribution indices aim to manage volatility risk.

Both approaches target improved performance metrics on a risk-adjusted basis, and are growing in popularity among investors.

Portable alpha

Bolstering a smart beta fund with a portable alpha component can heighten portfolio returns while adding an element of diversification to the strategy.

The portable alpha approach targets a separate source of excess return which is uncorrelated from the smart beta strategy itself. Key to this investment model is that instead of buying the smart beta fund directly, a portable alpha strategy invests in the index synthetically through alternative instruments.

Portable alpha is implemented by buying a derivative linked to the smart beta index, often in the form of futures or swap contracts. This provides exposure to the underlying index with relatively little upfront capital outlay (aside from financing costs), making room for an additional alpha strategy which is uncorrelated from the index.

For example, buying a futures contract linked to a minimum volatility smart beta index provides beta exposure while freeing up cash for a separate alpha investment – or “portable alpha”.

Since portable alpha should be uncorrelated from the beta component, a fitting portable alpha source for this example could be a high quality fixed-income alpha portfolio which would have little if any correlation to equities (or the smart beta fund).

A portable alpha strategy can lift overall investment returns while bringing diversification benefits to a portfolio, thereby lifting a strategy’s risk-adjusted performance.

Achieving alpha

Virtually no alpha strategies are entirely passive, since they require active data and information analysis, as well as decisions and strategies to target market inefficiencies and risks.

Many market commentators argue that in theory, the search for these inefficiencies will eventually drive prices to equilibrium as these abnormalities and information advantages are exploited. This implies gradually diminishing sources of alpha and waning alpha returns, in theory.

However, for at least the foreseeable future, investors can extract alpha from various underlying risks in the market through active fund management, alternative indices and portable alpha, among other means.

The factors behind alpha returns can be combined to control risk (value and momentum strategies, for example), while others aim primarily to manage volatility risks (low volatility and equal risk contribution indices).