Portable alpha strategies

Mar 15, 2019

Key points

  • Portable alpha strategies can potentially help generate returns above a market index while maintaining a target asset allocation.
  • Portable alpha strategies effectively separate the beta and alpha returns sources of an investment, giving investors greater flexibility to build portfolios.
  • We believe that robust liquidity management of the beta exposure and selecting an uncorrelated alpha source are key in portable alpha implementations.

Introduction

In the past few years, there has been a renewed interest in portable alpha strategies. Many institutional investors, such as public pensions and foundations and endowments, have been exploring ways to improve returns as the broader markets have become more challenging. Today, as many see a potential regime change to higher market volatility, we believe these portable alpha strategies have become the next logical step in building resiliency into portfolios while still adhering to a target asset allocation. In the following pages, we will define and explain the mechanics of portable alpha strategies, review the potential portfolio construction benefits, and share key considerations when beginning to implement a solution.

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 Barclays U.S. Aggregate Bond Index. A typical strategy is composed of:

      1. A target index exposure, often called the “beta” component, and
      2. A separate source of excess returns, often called the “alpha” component

Portable alpha strategies effectively separate the returns of a target index, or beta, and the returns of an alpha-seeking manager, or alpha. This separation allows the returns of the alpha component to be “ported” on top of whatever market index exposure is desired by an investor.

Potential portfolio construction benefits

A portable alpha approach can help overcome some of the historical challenges of portfolio construction. Traditionally, institutions invest in specific markets based on their target asset allocation plan. Within each asset class they select investment managers who primarily invest in securities from within their target asset class. Effectively, the asset allocation decision and the source of alpha are linked together. Linking these decisions is constraining for both the investor and the investment manager. For the investor, it constrains the universe of managers that they can select from to help generate alpha, and for the investment manager, it constrains their investible universe and limits their potential alpha sources.

A portable alpha strategy can allow investors to separate asset allocation from alpha generation. Investors choose the optimal manager who can generate their target beta exposure efficiently. Separately, high quality alpha-seeking managers can be selected from a far wider universe of managers in an effort to generate excess returns.

To illustrate this, consider an investor seeking an investment with an excess return over the U.S. stock market. A portable alpha strategy can allow the investor to get exposure to the U.S. stock market (e.g. S&P 500 Index) through a beta investment, and then to separately choose an active manager that they believe has the best active return potential (e.g. a global multi-asset long/short strategy). This can give the investor the flexibility to find an alpha-seeking manager without being limited to choosing from managers focused on U.S. stocks.

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 which typically only require a small amount of cash in the form of a margin requirement to achieve the desired exposure. As a result, there is excess cash to allocate to the target alpha-seeking manager. Finally, the third step of the process is to invest the remaining funds in an alpha-seeking manager and a cash reserve.

Example of implementing a portable alpha strategy

Example of implementing a portable alpha strategy

Source: BlackRock analysis. The illustrative strategy was constructed as stated above and is shown for illustrative purposes only to demonstrate a simplified example of how to construct a portfolio alpha strategy. It is not representative of any portfolios managed at BlackRock.

The return generated by the overall strategy is a function of how much capital is allocated to the alpha-seeking manager, how much alpha they generate, and the return of the index exposure. The use of market-linked instruments to create the target index exposure comes with a financing cost, typically a cash rate (e.g. LIBOR) plus a spread. 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 target index exposure.

The key implication for investors is that if they seek above market returns they don’t necessarily have to choose a manager with an aggressive risk and return profile. A manager with a more defensive profile may maximize the probability of consistently outperforming the financing rate overtime, and thus be additive to the portfolio.

Using the example in the diagram above, let’s assume that the target index is created at a financing cost equal to LIBOR. The 50% of the portfolio that is invested in cash (which includes the 25% cash to replicate the index plus the 25% reserve) should be able to generate a LIBOR return. The alpha-seeking manager is then looked upon to generate LIBOR plus some level of excess return. As 50% of the overall portfolio is invested with the alpha-seeking manager, the investor would receive 50% of the alpha generated by the manager. If the alpha-seeking manager was targeting LIBOR + 6%, then the overall investment would have an expected return of the target index + 3% to the investor.

Key considerations for implementation

When implementing a portable alpha strategy, investors should identify alpha-seeking managers that limit their beta exposure and have a history of delivering uncorrelated alpha. Additionally, investors constructing portable alpha strategies should apply stress tests to determine the size of the cash reserve required to sufficiently cover both mark-to-market moves of the target index and any potential changes to margin requirements on market-linked instruments used to create the exposure.

Potential risks

Similar to all investments, there are potential risks involved when employing a portable alpha framework. Primarily, it is possible for the alpha-seeking manager to underperform the LIBOR rate of return it needs to exceed. Additionally, the active-seeking manager may also generate negative absolute returns. Finally, market-linked instruments may not be perfectly correlated with a market index over time, creating tracking error that may differ from initial return expectations.

Conclusion

A portable alpha investment framework, or one that effectively separates the alpha and beta components of a portfolio, can help both investors and asset managers pursue better portfolio outcomes.

We believe portable alpha strategies have become the next logical step in building more efficient portfolios that seek returns above a market index while maintaining a target asset allocation.

Download now

Shawn Steel
Senior Product Strategist, Systematic Fixed Income
Tom Parker
Managing Director, Systematic Fixed Income