Portable alpha strategies

Diversification and asset allocation may not fully protect one from market risk.

Defining portable alpha

The objective of a portable alpha strategy is to generate returns in excess of a specific market index such as the S&P 500 Index or Bloomberg U.S. Aggregate Bond Index. Portable alpha strategies consist of a target index exposure, or “beta” component, and a separate source of excess return opportunities or “alpha” component.

Portable alpha strategies seek to effectively separate the returns of a target index (beta) and the returns of an alpha-seeking manager (alpha). This separation potentially allows the returns of the alpha component to be “ported” on top of the investor’s desired market index exposure.

Mechanics of portable alpha strategies

There are three key steps to implementing a portable alpha strategy. First, the investor chooses a target index for their beta exposure. Second, the target index is replicated using market-linked instruments. This part of the portfolio requires a small amount of cash in the form of a margin requirement to achieve the exposure, but also comes with a cash financing cost. As a result, there is excess cash to allocate capital. The final step is to invest the remaining funds in an alpha seeking source and a cash reserve.

Example implementation and expected potential return of a portable alpha strategy

For illustrative purposes only. There is no guarantee expected returns will be realized. “Expected return” in the chart above assumes a 20% cash reserve and 20% cash margin that can be reinvested at the same rate as the cash financing cost to fund the market-linked instruments. Thus, the expected return is equal to the return of 100% market index plus 60% alpha source minus 60% cash financing rate. The hypothetical performance returns are provided for illustrative purposes only and demonstrated index performance and are not meant to be representative of actual performance or to project returns, does not exist and therefore, invariably show positive rates of return, does not reflect the deduction of any fees or expenses that might normally apply. The allocation decisions in the hypothetical were not made under actual market conditions and cannot account for the financial risk. One cannot invest directly in an index. Past hypothetical performance results are not indicative of future returns.

Thus, the return of the portable alpha framework is determined by how much capital is allocated to the alpha source, how much return it generates, the return of the index exposure, and the cost to finance the index exposure. It is important to note that in a portable alpha framework, the alpha-seeking manager is additive to the portfolio as long as they produce positive returns greater than the cost to finance the index exposure.

Understanding expected returns

Using the simplified example in the chart above, let’s assume that 100% of the target index exposure is created using market-linked instruments at a financing cost of 4.0%. Due to the fact that 40% of the index exposure is backed by physical cash (20% margin and 20% reserve), it can be reinvested in a cash rate to match the financing cost rate. Thus, the remaining 60% of exposure comes at a cost of 2.4%

Next, the alpha-seeking manager seeks some level of positive return. As 60% of the overall portfolio is invested with the alpha-seeking manager, the investor would receive 60% of the return generated by the manager. If the alpha-seeking manager targeted a 10% return, then the overall investment would receive the expected return of the target index and an additional 6% from the alpha source, minus 2.4% for the cash financing cost.

Overall, in this hypothetical example, this return occurred with the assumption that the targeted return alpha and index returns would equate to a return to the investor equal to the market index return plus 3.6%, with the excess return driven by the alpha-seeking portfolio's return over the financing cost.

Potential risks

Like all investments, there are potential risks involved in a portable alpha framework. Primarily, it is possible for the alpha-seeking manager to underperform the cash rate or generate negative absolute returns. Market-linked instruments may not perfectly track a market index over time, creating tracking error that may differ from initial return expectations. Secondarily, market-linked instruments have the potential for margin calls after large market moves that may require adjustments in the whole portfolio.

Putting portfolio capital to productive use

One key advantage of a portable alpha framework is investors can untether a portfolio’s active risk budget from the beta allocation without disturbing it. Importantly, it unlocks portfolio capital that can be used in seeking excess returns in areas of the global financial markets that have more potential to generate alpha. For investors, building the optimal asset allocation for the market return, or “beta” component, of your portfolio is quite different than the optimal capital allocation seeking excess returns, or “alpha” component, of your portfolio.

In equity portfolios, we find that market capitalization is a common driver of portfolio asset allocation weights, but it may not be an optimal starting point for active risk allocation. In fixed income portfolios, we find that most managers have low active risk budgets and derive the majority of their active return from tilts into credit-sensitive securities—essentially delivering beta and a potentially high correlation to equities.

Portable alpha strategies can help solve these issues across both asset classes. They can allocate active risk based on other alpha opportunity sets in equities, and they may help construct a more diversified source of active return than traditional bond portfolios.

Fixing the alpha-beta mismatch in equities

The concentrated nature of capitalization-weighted indices is a difficult starting point for active risk budgeting, as it dramatically tilts the portfolio allocations away from the more diverse, high-breadth market segments. The figure below breakdowns the MSCI All Country World Investable Market Index IMI into conventional segments in which clients typically organize their equity allocations.

While following capitalization-weighted indices can be a well-prescribed starting point for an overall equity market beta allocation, it can also have consequences on the effectiveness of alpha-seeking efforts. Most notably, the amount of capital allocated to active managers in each category is typically bound with its market cap weighting in the broader index.

For example, US large and mid cap exposure is typically over half the overall equity allocation, while international large cap is roughly a quarter. The other more diverse equity segments, and where risk-adjusted returns potential may be greater based on top-quartile manager returns, combine to be just under 25% of the total equity exposure.

Manager selection can only go so far

In our experience, finding persistently skilled, top-quartile performing managers can be a challenge. Exceptional manager selection is still bound by asset class limitations.

As shown in the chart above, even if you were successful in identifying a top-quartile manager in the US large and mid-cap segment, the overall portfolio impact might be muted. Why? Selecting a top-quartile manager in the segment would have only resulted in an information ratio of 0.24 on about 59% of your total equity allocation. On the other hand, selecting a top-quartile domestic market international small cap manager would have been far more rewarding with an information ratio of 0.54, but that would likely only be a small portion (~3%) of your total portfolio.

Manager selection matters less if the starting point of an asset allocation is not aligned with alpha opportunities. Portable alpha can help with this alpha-beta mismatch.

Putting portable alpha to work in U.S. equities

What are the potential benefits of a portable alpha framework in equities? Broader opportunities to generate alpha in the largest parts of the portfolio where meaningful outperformance may be difficult.

Let’s assume we want to generate more return from a US large cap allocation. If we use a portable alpha approach to replicate S&P 500 beta exposure and make a 60% investment into an alternative strategy such as a global long/short market neutral strategy, the portfolio outcomes can be much more impactful than manager selection alone.

Global long/short market neutral strategies are typically high-breadth portfolios that are able to look across global equity markets for opportunities, not just a particular market segment like US Large Cap securities. Importantly, because these types of strategies take both long and short positions, they often seek to take advantage of security dispersion in markets, and do not add significantly more beta exposure. As a result, the returns can be less dependent on market direction. This type of uncorrelated return profile can potentially act as a compliment to the index exposure in up markets and a buffer against volatility in down markets.

The figure below compares the alpha generated by the top-quartile of US large cap core equity manager to a portable alpha framework that replicates the S&P 500 Index through market-linked instruments while holding a 60% allocation to an alternative strategy, represented by the HFRI 500 Equity Market Neutral Index.

Traditional long-only results compared to a portable alpha approach

Hypothetical 10-year annual alpha generation by approach

Case studies are for illustrative purposes only. This represents model driven allocations, depicted above, to the underlying top-quartile (25th percentile rank) managers in the eVestment Large Cap Core category as of September 30, 2024. The underlying performance is based on actual historical performance. “Traditional Long-Only Approach” alpha data based on the 10-year average annual alpha generated over the S&P 500 Index for the top-quartile (25th percentile rank) manager in the eVestment U.S. Large Cap Core category. The index return was 12.85% and the manager return was 13.13%. “Portable Alpha Approach” alpha calculated as 60% of the average annual return of the HFRX Equity Market Neutral Index Flagship Funds minus 60% of the ICE BofA 3-Month Treasury Bill Index. The HFRX index return was 3.28% and the T-Bill return was 1.67%. HFRX Index constituents are comprised of private hedge funds published by Hedge Fund Research, Inc. Managers. The average top quartile manager delivered 0.28% alpha (net) after all fees and expenses have been deducted. In a portable alpha approach, a manager delivered 0.97% alpha (net) after all fees and expenses have been deducted. All performance rates are net of fees. The aggregate performance of the model is hypothetical, and the model is formulated with benefit of hindsight, subject to limitations, and the hypothetical performance returns are not meant to represent actual performance or project returns, does not exist and therefore, invariably show positive rates of return, do not reflect the deduction of any fees or expenses that might normally apply. The allocation decisions in the hypothetical were not made under actual market conditions and cannot account for the financial risk. One cannot invest directly in an index. Past hypothetical performance results are not indicative of future returns.

As you can see, the realized 10-year annualized alpha of a top-quartile manager is 0.28% (net). In comparison, 60% of the HFRX Equity Market Neutral Index return of 3.28% (which represents the average return of the managers in the category) results in an annual alpha of 1.97%. After adjusting for 60% of the 1.67% average annual financing costs of the beta exposure over the time period (as measured by the ICE BofA 3-Month Treasury Bill Index) the total alpha of the approach is 0.97% (net) annually. As you can see, the distinct structure of a portable alpha strategy may lead to greater return potential than what is possible through manager selection alone.

In a portable alpha framework, untethering alpha generation from the confines of market-cap weighted asset allocations allows investors to optimize return potential away from segments of the markets that can potentially be more difficult to generate meaningful excess returns.

Navigating a higher rate environment in fixed income

Rising yields for global fixed income securities have boosted their appeal, but a higher inflation environment, coupled with increased dispersion, and lower diversification benefits between bonds and equities provide new challenges for investors. Core fixed income, as a major portion of some investors’ asset allocations, may no longer work to cushion against risk asset selloffs or the best use of portfolio capital. Compared to traditional long-only approaches, portable alpha strategies can help investors generate higher levels of active risk in their portfolio, and these strategies can allow investors to generate a higher percentage of idiosyncratic active risk in their return stream. In this analysis, we look at Core and CorePlus U.S. fixed income managers to illustrate how portable alpha strategies can improve an investor’s return potential and reduce overall portfolio correlation to the credit and equity markets.

Source of active return matters

In the figure below, we regressed 10 years of Core Bond and CorePlus manager returns against a simple three factor model which included credit risk, equity risk, and rate risk. We found that approximately 55% of Core Bond managers and 63% of CorePlus managers’ excess returns were explained by these static exposures. All figures are net of fees.

Of the three factors, the credit risk factor exposure was most explanatory. This implies that many active Core and CorePlus bond managers have relied on an overweight to credit-sensitive securities to drive excess return. Simple linear regression has been conducted to analyze the relationship between common factors and performance.

This has a very important, but often overlooked, effect on total portfolio diversification. The credit overweight may boost returns in up markets, but it may also result in larger fixed income drawdowns in periods of equity sell-offs—the very time when investors may need the diversification of core bonds.

Putting portable alpha to work in fixed income

What are the potential benefits of a portable alpha framework in core fixed income? The ability to increase active returns and at the same time seek idiosyncratic, equity-diversifying return streams.

Instead of chasing yields in fixed income markets, using alternative strategies as the alpha source in a portable alpha framework can help maintain the equity diversifying returns investors come to expect from bond allocations. Alternatives, like multi-strategies are more focused on idiosyncratic return streams that are the result of relative value or long/short security selection opportunities.

The figure below compares the alpha generated by the top-quartile Core and CorePlus bond managers to a portable alpha framework that replicates the given benchmark while holding a 60% allocation to an alternative strategy, represented by the HFRI 500 Relative Value Multi-Strategy Index.

As you can see, the realized 10-year annualized alpha of a top-quartile manager is 0.23% (net) and 0.58% (net), respectively. In comparison, a portable alpha strategy with a 60% allocation to the median multi-strategy manager would have resulted in total alpha of 2.21% annually, after adjusting for financing costs.

Comparing results of a traditional long-only and portable alpha approach

Hypothetical annual alpha generation based on approach

Once again, we believe the structural advantage of the portable alpha strategy can translate to better return potential even against top-performing managers in the category. During this time when investors are struggling with greater uncertainty in financial markets, portable alpha strategies can represent a way for investors to increase the overall level of potential return from their core allocations. Equally important, portable alpha can help preserve the diversifying role of bonds by seeking more idiosyncratic sources of return that are less correlated with credit risk.