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.