Institutional Investor's Alpha Magazine - December 2007/January 2008 - (Page 52)

Portable Alpha improve portfolio efﬁciency. For – traditional asset managers, constraints on short-selling remain the biggest practical hurdle to creating optimal portfolios. In spite of the impressive growth of alternative strategies in recent years, 90 percent of all institutional and retail money is still managed in long-only portfolios. The inherent deﬁciency of long-only portfolios can be expressed in academic terms by talking about information and transfer coefﬁcients, the strength of a fund manager’s forecasting signal and how this is translated into portfolio weights. But the easiest way to think about the problem is in terms of the day-to-day reality that long-only money managers face. As of mid-December the 100th-biggest stock in the Standard & Poor’s 500 index was insurer Allstate Corp. It has a weight in the index of 0.23 percent. The largest negative active bet a long-only portfolio manager can make on Allstate — simply by not owning it — is –0.23 percent. The 200th-biggest stock in the index, casino operator Harrah’s Entertainment, has a weight of 0.12 percent. Allstate and Harrah’s are among the biggest and most liquid stocks in the U.S. market. But in a typical portfolio of 70 to 80 stocks, a –0.23 or –0.12 percent allocation would make no meaningful contribution to performance. Freeing managers from the short-selling constraint, if they have skill, is a sensible course of action. There are two widely held misconceptions about portable alpha. First, most investors believe the only way to extend alpha beyond its asset class is by porting it onto another asset class. In fact, the same portable alpha effect can be achieved through permitting unconstrained short sales on a ﬁ xed alpha portfolio. There is no variance between the two approaches. Second, one of the imagined appeals of portable alpha is that it introduces a noncorrelated return stream to the portfolio. The truth be told, the portable alpha has exactly the same correlation as the ﬁ xed alpha. Further, 130/30 and similar extension strategies are just special cases of portable alpha. Such approaches replace one constraint — no short-selling — with other arbitrary constraints, such as applying 30 percent leverage. A 130/30 strategy is a portfolio compris— MARK KRITZMAN ing a 130 percent long exposure to a set of securities expected to outperform a benchmark and a 30 percent short allocation to a set of securities expected to underperform. By including short positions, a 130/30 portfolio solves the problem faced by long-only investors that their negative views can contribute very little to portfolio performance. Such strategies should be more efﬁcient than long- Table 1: Stock and bond returns The following depicts a world with only two stocks, of equal size, and a single government bond. The hypothetical returns for ten years for all three securities and for an equal-weighted stock index are shown below. The average returns appear in the bottom row. Stock A 10.00% –8.00 0.00 21.00 2.00 29.00 24.00 13.00 –18.00 7.00 8.00 Stock B –6.00% 14.00 –16.00 –5.00 18.00 10.00 32.00 40.00 38.00 –5.00 12.00 Stock index 2.00% 3.00 –8.00 8.00 10.00 19.50 28.00 26.50 10.00 1.00 10.00 Bond –9.00% 22.00 7.00 12.00 –8.00 7.00 8.00 5.00 10.00 6.00 6.00 Source: Mark Kritzman. “For fund managers with long-only backgrounds, the halfway house of 130/30 might make some practical sense.” only investing, provided that the manager has skill. But they are almost always not the optimal strategy. The optimal one is to allow the particular amount of short- selling that is consistent with an investor’s risk preference, such that the net market exposure equals the desired weight of the asset class in question. Actively managed portfolios have two potential sources of returns — alpha and beta. The passive return, or beta, comes from bearing the systematic risk of an asset class. A beta portfolio can be created by allocating to a passive benchmark; in the case of U.S. equities, the benchmark is typically the S&P 500. The active return, or alpha, is the expected return earned on away-frombenchmark positions, which, when combined, represent an investor’s alpha portfolio. Investors look to portable alpha as a way to strike an efﬁcient balance between the active and passive exposures in their portfolios. For an alpha to be portable, it must be self-ﬁ nancing. Portable alpha is a combination of long and short secu rity holdings whose weights sum to zero, therefore requiring no capital. For example, an investor might expect a group of stocks with low price-to-earnings multiples to outperform a broad market index. That investor could create a portable alpha by selling the market index and using the proceeds to ﬁnance the purchase of stocks with low P/E multiples. This combination of long and short securities could be introduced to a portfolio without requiring the sale 52 • INSTITUTIONAL INVESTOR’S ALPHA • DECEMBER 2007/JANUARY 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - December 2007/January 2008

Institutional Investor's Alpha Magazine - December 2007/January 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Liberal Returns The Good Guy: Inner-city MVP Cover Story: Marathon Men Interview: Rizk Management Profile: Living on Hostile Ground Profile: Buy and Hold In Theory: The Fallacy of Portable Alpha Strategies: Changing Course Alpha Bytes: Behind the Scenes Unhedged: Commentary: An Activist Alternative

Institutional Investor's Alpha Magazine - December 2007/January 2008

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