Typically, investors compare their asset manager’s performance to a market index to determine if the manager has beaten the market. An investor might compare a large-cap asset manager’s performance with that of the S&P 500 index, for example. Unfortunately, the investor still ends up paying the manager to capture the broad market’s performance (which can usually be acquired more cheaply with simple financial instruments such as index futures or exchange-traded funds). This is true even in those cases in which the investor does not want that broad exposure. An investor might want to invest with a leading large-cap stock picker, for example, but might not want broad exposure to the S&P 500. He might believe the small-cap universe of stocks is poised to outperform the large-cap universe, and therefore want exposure to a small-cap index such as the Russell 2000.

These investors can now avail themselves of an investment strategy that allows them to wash the passive market performance, known in financial parlance as "beta," out of the investment and capture only those returns derived from the manager’s skill, known as "alpha." This approach, called "portable alpha," has been embraced in recent years by sophisticated institutional investors; it is now catching on with some private investors.

Portable alpha essentially allows an investor to design a two-part portfolio. One part allows him to capture the alpha generated by one or more specific manager’s skill; the other captures the investor’s preferred flavor of passive market beta. It frees investors from the heretofore necessity of obtaining both their alpha and beta from the same asset class. "Asset allocation and the quest for alpha can be managed independently," says Ed Kung, alternatives product manager with Babson Capital Management in Boston. "The alpha selection should be done on an independent basis, based purely on a manager’s skills, rather than on an asset class."

Hellenic Choices
This separation of alpha and beta offers several potential benefits. The main advantage is flexibility. The approach lets investors decide precisely how much–and what type of–alpha and beta exposures they want. Traditional portfolio construction, based solely on asset allocation choices, cannot achieve this–investors cannot control how much of their return comes from alpha and how much from beta. Advocates of portable alpha argue that this is akin to investing blindly. The ability to determine if asset managers are really earning their fees is another advantage. Anyone can acquire beta returns by taking broad, static market exposures; investment managers are only valuable if they generate alpha. "Why should we pay a manager for beta when we can get that beta cheaply in the marketplace using financial instruments?" Kung asks.

A portable alpha strategy lets investors decide precisely how much alpha versus beta exposure they wish to take.

Kelly Cliff, senior vice president and head of global manager research at investment consulting company Callan Associates in San Francisco, explains: "Alpha only exists for a strategy that invests with an active manager attempting to outperform his specific benchmark. So in real general terms, if you have a small-cap manager that generates a return of 12 percent for the quarter, and you have the Russell 2000 [small cap] index returning 10 percent for the quarter, then you could say that 10 percent of that return came from beta, with the extra 2 percent coming from alpha."

In this example, assume an investor has $100 million of equities allocated entirely to the U.S. large-cap stocks that comprise the S&P 500 index. If this investor decides he wants to increase the probability of his portfolio outperforming the S&P 500, the traditional way to do so is to sell some shares and reinvest in a riskier, but potentially more rewarding, asset class–such as small-cap U.S. equities. This investor might, depending on his risk appetite, split the portfolio 70/30 between large-cap and small-cap equities.

But such a reallocation is a fairly blunt tool, and it only provides the investor with two separate blobs of beta, rather than any skill-based outperformance. A better approach is to choose specific small-cap stock pickers who have proven their ability to outperform their peers. However, as Cliff points out, "The problem here is that historically, if you want more small-cap exposure because you like the amount of alpha you can generate there, you’ve had to take along the beta piece, and the volatility of that beta piece, as well."

This investor wants broad market exposure to the S&P 500, but only wants to harness the skill-based outperformance of the small-cap manager, not an exposure to the entire Russell 2000 index; he wants to combine large-cap beta with small-cap alpha.

Still With Me?
The broad brush-strokes of this strategy are fairly easy to grasp. First, the investor engineers his beta exposure. Continuing with the example above, where the goal is beta exposure to the S&P 500 and small-cap alpha, the investor can take a small amount of the $100 million in capital and purchase index futures contracts on the S&P 500. These are widely traded, standardized instruments available through derivatives exchanges that allow an investor to buy an index at some point in the future for a set price today. Say the index is at 1,000 today and the investor buys a futures contract that allows him to buy it at 1,100 in three months. If the index rises to 1,200, he has earned 100, minus whatever he paid for the futures contract. If it stays at 1,000, his loss is 100 plus the cost of the contract. Futures contracts are heavily leveraged, meaning an investor might be able to secure $100 million of three-month market exposure to the S&P 500 for only $6 million to $7 million. By purchasing a contract today at par, the investor locks in exposure to his beta: the performance of the S&P 500.

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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