What it means
Alpha is the extra return a manager earns above what the market delivers, after allowing for risk. Beta is the return that comes simply from being exposed to the market.
Most funds blend the two, so an investor who wants the manager's skill must also accept the manager's market exposure. Portable alpha breaks them apart.
The investor puts money into a strategy with alpha, such as a market-neutral hedge fund that aims to earn cash plus a few percentage points regardless of market direction. The investor then buys market exposure separately, usually through futures or swaps, which need only a small deposit.
The result is that the same dollar does two jobs. It earns the alpha strategy's return and also supports the market exposure bought with derivatives.
In principle, the investor gets the market return plus alpha, in whatever market they chose. Pension funds and endowments use it to improve returns without changing their asset allocation.
A fund that wants 60% in equities can hold equity futures for its beta while placing its cash in alpha strategies, so it can keep its target mix while seeking extra return. The risks are real.
If the alpha manager underperforms, the investor still owes the cost of the market exposure, and the gap can be large. Derivatives bring leverage, margin calls and counterparty risk, and the correlation between the alpha strategy and the market may not be zero in a crisis.
Costs also matter. The investor pays fees to the alpha manager, financing costs on the derivatives and trading costs, and the alpha must be big enough to cover all of them.
Careful due diligence on the alpha source is essential.
In practice
Real-world examples.
Example
A university endowment wants to keep 50% in equities but also hold a market-neutral fund. It buys equity futures to maintain its market exposure and invests the cash in the fund. The endowment keeps its intended mix and seeks extra return on top.
Example
A pension scheme with a long-term target of a 60% equity allocation uses portable alpha to add extra return. The trustees limit the amount of leverage and set rules for margin. A cash buffer is held in case futures prices fall sharply.
Example
An insurer separates the stock-picking skill of a manager from the market risk it does not want to bear. It hedges the manager's market exposure with futures and keeps the alpha. This lets the insurer pay for stock-picking skill without accepting extra market risk.
Formula
Calculation
Total return = alpha fund return + (market return - cash financing rate)
Suppose an investor places $100,000,000 in a market-neutral fund that returns cash plus 3%. Cash earns 2%, so the fund returns 2% + 3% = 5%.
The investor also buys index futures on $100,000,000. The index returns 8%, and the implied financing cost is the cash rate of 2%, so the overlay earns 8% - 2% = 6%.
Dollar return from the fund = 100,000,000 x 0.05 = $5,000,000.
Dollar return from the overlay = 100,000,000 x 0.06 = $6,000,000.
Total return = 5,000,000 + 6,000,000 = $11,000,000, or 11%, which equals the 8% market return plus the 3% alpha. If the alpha manager instead lost 2% relative to cash, the fund would return 0%, and the total would be 0 + 6,000,000 = $6,000,000, or only 6%.Case study
Seen in the real world.
Stonebridge Endowment is a fictional fund with $200,000,000 that wants to keep a market exposure but improve returns. In this illustrative plan, the investment committee puts $50,000,000 into an alpha strategy expected to earn cash plus 4% and buys index futures on the same $50,000,000.
With cash at 2% and the index at 8%, the expected return on this slice is 6% from the alpha fund plus 6% from the overlay, or 12%. That is 50,000,000 x 0.12 = $6,000,000, against $4,000,000 from simply holding the index at 8%.
The committee also stress-tests a bad year in which the index falls 20% and the alpha strategy loses 3%. The loss would be heavier than a simple index investment, so the committee sets a limit on the slice size and a margin reserve before approving the plan, and it asks the consultant to confirm in writing how the alpha manager's track record was verified.
Watch out
Common mistakes.
- Assuming alpha is guaranteed. Skill-based returns can disappear or turn negative.
- Forgetting financing costs. The overlay costs roughly the cash rate, which must be earned back by the alpha strategy before any extra return is left for the investor.
- Ignoring margin needs. Futures positions require cash when markets fall.
Questions
People also ask.
What is the difference between alpha and beta?
Alpha is the return from skill, and beta is the return from market exposure.
Why is it called portable?
Because the alpha can be moved onto any market exposure the investor wants by using derivatives.
Who uses it?
Mostly large institutions such as pension funds and endowments, which have the expertise to manage the derivatives and the cash needed to meet margin calls.
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