Institutional Investor's Alpha Magazine - December 2007/January 2008 - (Page 54)

Portable Alpha net exposures to stocks A and B are identical to the weights of these securities for the ﬁxed alpha strategy. You may wonder if the equivalence of ﬁ xed alpha and portable alpha works only when we maximize ending wealth. It does not. Whether we wish to maximize ending wealth, or use a particular utility function or metric, such as the Sharpe ratio, we can achieve the same result by investing in securities that ﬁ x alpha to its underlying market return as we can achieve by detaching alpha and porting it to other parts of the portfolio. Moreover, this invariance prevails even if we solve simultaneously for the asset mix along with exposure to active bets. There is, however, a special case in which portable alpha does improve portfolio efﬁciency. Suppose we do not want exposure to stocks as an asset class, but we would like to beneﬁt from a particular manager’s stockpicking skills. We can improve our portfolio’s performance by importing alpha from securities not already included in the portfolio and overlaying it on our existing portfolio, and we can accomplish this without incurring the market risk of the external source. We can also demonstrate another equivalence. Suppose we change the last return for stock A in Table 1 from 7 percent to 14.5 percent. With this simple change, the wealthmaximizing portable alpha strategy is to sell short stock A’s alpha in an amount equal to 4.6 percent and purchase stock B’s alpha in an amount equal to 91.4 percent, again preserving our 60/40 passive exposure to stocks and bonds. This strategy produces an expected ending wealth of $236.66. Again, we can replicate this outcome with a ﬁxed alpha strategy in which we combine a 40 percent government bond exposure with an 18 percent short position in stock A and a 78 percent long position in stock B. These exposures to stocks A and B are relative to the total portfolio. When we view them as fractions of the portfolio’s equity component by dividing by 0.60, they correspond to a 30 percent short position in stock A and a 130 percent long position in stock B, or, in other words, a 130/30 strategy. Thus a 130/30 strategy is nothing more than a special case of portable alpha. In this example, it happens to be optimal because it is contrived to be. In general, a 130/30 strategy will be suboptimal. There will always be some other long-short combination that is optimal and easily accessible without resorting to portable alpha or leverage. For fund managers with long-only backgrounds, the halfway house of 130/30 might make some practical sense, as it allows them to gain familiarity with the mechanics of short-selling. The motivation for ﬁrms’ jumping on this passing bandwagon from the hedge fund world, however, is rather more questionable. Hedge fund managers ought to have ﬁnely honed shorting skills and therefore should be able to manage the optimal portfolio regardless of how much short-selling is required. Conventional wisdom holds that we can improve portfolio efﬁciency by manufacturing a portable alpha from securities within a portfolio and extending it beyond its own asset class. But conventional wisdom is wrong. We can achieve the same level of expected return and risk by preserving the linkage between alpha and its underlying market exposure, without resorting to leverage and without changing a portfolio’s asset mix. Indeed, we can achieve the same exposure to the underlying securities with a ﬁxed alpha strategy as we can with a portable alpha strategy. Portable alpha is beneﬁcial only if it comes from securities that would not otherwise be held in the portfolio. The rush of new 130/30 products is nothing more than a particular example of a portable alpha strategy that is optimal under very speciﬁc circumstances. The products are a step toward greater portfolio efﬁciency but are far from being an optimal solution in most cases. Permitting any combination of longs and shorts, without resorting to leverage, is all that is needed to arrive at a truly optimal portfolio. Although portable alpha does not necessarily improve portfolio efﬁciency as it applies to expected return and risk, it may beneﬁt the portfolio in other ways. Long-only managers, for example, charge fees based on a portfolio’s total assets, when typically 90 percent or more of a given portfolio tracks the market. By separating alpha from beta, it becomes clear how much of the portfolio represents the manager’s active bets versus the fraction that could be replicated with a low-cost index fund. Portable alpha renders transparent the division of active and passive management within a port folio, thereby enabling investors to pay active fees for that part of the portfolio which is actively managed and passive fees for the part that is passive. There are, of course, simpler ways to achieve this distinction, but the virtue of portable alpha may be that it accelerates the shift to more equitable fee structures. Mark Kritzman is president and CEO of Cambridge, Massachusetts–based Windham Capital Management and senior partner of State Street Associates, the research arm of Boston’s State Street Global Markets. He also teaches a course in ﬁnancial engineering at the Massachusetts Institute of Technology’s Sloan School of Management and serves on the boards of the Institute for Quantitative Research in Finance and the Investment Fund for Foundations, as well as on the editorial boards of several ﬁnance journals. Kritzman has written numerous articles for academic and professional journals and is the author of six books. For this article, he beneﬁted from the assistance of MIT professor emeritus Paul Samuelson and Andrew Capon, editor-in-chief at State Street Global Markets Research. 54 • 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

For optimal viewing of this digital publication, please enable JavaScript and then refresh the page. If you would like to try to load the digital publication without using Flash Player detection, please click here.