Using Portable Alpha to Enhance Returns and Manage Risk

Subscribe to our Newsletter

Portable alpha strategies allow investors to add a separate alpha component to a beta-yielding market investment. Though relatively limited in application (for example, they are not suitable for exchange-traded funds or Shariah-compliant funds),Instead of investing directly into a market fund, portable alpha investors use a derivative contract that tracks a market index such as the S&P 500. The use of a derivative means cheap exposure to the market since little upfront cash is needed, leaving extra capital that can be invested in a separate alpha fund.Since the source of alpha (which can be obtained through a hedge fund or risk premia investment) can be added onto any market investment, it is called ‘portable’ or ‘transportable’.

Portable alpha strategies have in recent years become relatively popular among pension funds and other investors, partly because of the low-return environment engulfing world markets. Like hedge funds, portable alpha strategies are usually only accessible to large institutions and high net-worth investors.

The financial term beta refers to exposure to the broad market, which is often gained from investing in benchmark indices such as the S&P 500 Index. Further, each stock or portfolio has a beta element, the value of which tells investors how sensitive that investment is to market movements.

In a portable alpha strategy, market exposure (beta) is obtained synthetically through derivatives. Market investments are associated with passive fund strategies, which aim to track the performance of benchmark indices.

Alpha, meanwhile, refers to excess returns above what the market offers, and measures the value added by active fund management or superior strategies.

One of the major risks of portable alpha strategies is that they rely heavily on derivatives and borrowed funds, which means they can bring on hefty losses if markets make sudden downward turns. This risk is partly mitigated by the fact that portable alpha strategies add diversification to overall portfolios, since the alpha component is separate from the market fund.

Another restriction on the success of portable alpha strategies is that sources of alpha seem increasingly hard to come by. And alpha sources are quickly taken advantage of when they do appear, as fund managers race to exploit them.

Additionally, fund managers tend to charge high fees for portable alpha strategies.

How it works

Instead of direct investments into a beta fund (like the S&P 500 Index), portable alpha strategies get exposure to the index through derivatives like futures or swaps. This requires little upfront capital outlay, leaving the bulk of the available capital free for an alpha investment – preferably a liquid one.

Excess return (alpha) is generated if the alpha strategy’s returns exceed the financing costs associated with using derivatives.

Proponents of portable alpha strategies argue that the diversification benefits of these strategies helps to manage total portfolio risk and leads to better risk-adjusted performance metrics. Ideally, the alpha component has little correlation to the beta portfolio.

In the case of margin calls, the assets in the alpha fund will likely be needed to cover the margin call. This means the alpha portfolio should target liquid investments.

Sources of portable alpha

Portable alpha is often sourced from absolute return strategies like hedge funds and risk premia. Hedge funds and risk premia employ long-short trades to generate returns irrespective of the performance of financial markets, and can use returns-boosting tools including leverage.

In the event of a market downturn, the beta portion of the portable alpha strategy will decline, however the alpha component can add positive absolute returns through long-short trades.

Portable alpha strategies might not be suitable for investment approaches including Shariah-compliant investing. This is because risk premia approaches are questionable under Shariah law since they use long-short trades.

Adding a portable alpha source allows investors to generate a market-beating performance in assets which usually are not able to beat the market.

Among the tools available to measure the success of portable alpha strategies is the information ratio. The information ratio gauges a portfolio manager’s ability to generate excess returns while also taking into account the consistency of returns.

Risk premia strategies target risk factors, as do smart beta indices (which were born from the rise of indexing and factor investing). quantitative data analyses.