TOP VIEW: Investors who wish to choose when to passively ride a market up and down and when to hire skilled managers to wring out returns can now employ a strategy called "portable alpha" to do both at the same time. The approach has been widely embraced by sophisticated pension funds and other institutional investors, but it poses some significant challenges to private investors–not the least of which is the need to grasp its details. Despite this, the strategy’s advantages are spurring Wall Street to find ways to apply it to private clients’ portfolios.

The $90 million-plus left over can then be invested with the high-quality small-cap managers. However–and this is crucial–the investor then needs to wring the small-cap beta of the small-cap exposure by selling futures against it. In our example, he would most likely sell index futures linked to the Russell 2000 small-cap index. This is the reverse of his approach with the S&P 500, and it achieves the opposite goal: By selling this futures contract, he agrees to hand over the small-cap market performance for the subsequent three months to someone else. He is then left with the small-cap manager’s out- or underperformance–the alpha.

The visible result of this series of transactions gives the strategy its name, as Rob Blackwell, managing director of research and strategy at the Russell Investment Group in Tacoma, Wash., explains. "You now have a combination of exposure to small-cap managers, a short position in the Russell 2000 and a long position in the S&P 500, so you’ve effectively taken the alpha from the small-cap manager and ‘ported’ it onto the S&P 500," he notes.

The concept can, in theory, be applied to any number of markets, as long as tools such as index futures, swap contracts or exchange-traded funds exist to acquire and discard the betas per the investor’s preferences. A bond investor who wishes to harness hedge fund alpha, for example, could buy futures on a bond index and place a large amount of cash with hedge fund managers, while shorting an appropriate hedge fund benchmark. In this case, the hedge fund manager’s alpha would be ported onto the passive bond portfolio. "You pick an asset class where you think the rewards from active management are good, you invest in that asset class, and then you transport that active management reward back to one of your mainstream asset classes," Blackwell says.

Complex Executions
The devil in this strategy is in the logistical details. "It is a fairly complex strategy of employing futures contracts, and then applying returns from elsewhere onto those contracts," explains says Greg Friedman, chief investment officer with Pittsburgh investment company Greycourt. "Most individuals, and even those with multiple hundreds of millions of dollars, are just not that comfortable stepping out of the mainstream and using futures contracts to that degree."

Also, portable alpha is not a fire-and-forget strategy; it requires constant oversight. Margin positions have to be maintained. The underlying investments have to be constantly monitored, with the proportions of capital allocated to each part adjusted quite regularly, depending on market behavior. Using the small-cap, large-cap example again, as the value of the small-cap investments go up and down, the size of the hedge sold against that part of the portfolio needs to be modified to reflect that variation in value; the exposure to the large-cap part must also be adjusted. "You need someone sitting there watching the values of the various pieces of the portfolio, making sure the hedges are in place and working properly," Blackwell says.

Taxes may be another hurdle for U.S. private investors considering this approach. The use of derivatives such as futures contracts in a portable alpha strategy may convert the long-term capital gains of a large-cap stock portfolio into a series of short-term gains, which are taxed at a higher rate.

This is one significant reason the strategy has taken deepest root among tax-advantaged professional investors, such as pension funds. However, some providers are putting the approach before the private client community. Babson’s Kung says, "We are currently in the process of talking to family offices and endowment foundations, in addition to traditional pension providers." Interest from private investors is spurring banks and asset managers to innovate ways to make portable alpha more accessible. "The major fund-of-funds providers are either thinking about, or are in the process of, reinventing themselves to become portable alpha providers," Kung says.

Portable alpha strategies, like many innovations germinated in the institutional investment community, will most likely evolve into a useful tool for the private investor community, possibly in the near future. At that point, an investor’s real mental challenge will not be grasping the intricacies of the strategy’s execution–it will be the vastly greater intellectual leap required to clear the chasm between traditional asset allocation and this new frontier in portfolio construction.

John Ferry is an Edinburgh, U.K.-based financial journalist and a senior correspondent for Worth.

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