Portable Alpha Example

The CFA program is great for getting a wide survey of techniques you might want to add to your investing toolbox. Today’s material is based on Volume 4, Reading 32, Section 7.3 of the CFA Level III 2011 Curriculum.

In one corner, there’s you. You’re an expert picker of small cap stocks. Last year, when the US Small Cap universe returned -5%, you returned +3%. Way to go!

In the other corner, there’s a portfolio manager who lives in Japan. He’d like to hire you and use your picks to generate alpha, but his clients compare their portfolio returns to the MSCI Pacific Index, which happened to deliver 35% last year. If he’d used your picks and returned only 3%, they would have been furious!

Is there a way you two can work together, without requiring you to start developing an expertise in Pacific Rim companies?

Absolutely, it’s called portable alpha, and is also known as alpha beta separation. What that portfolio manager can do is buy a Pacific Index for the beta exposure to the clients’ benchmark, short a benchmark from the universe you pick from, and give you the proceeds to take long positions in your universe. What return does such a portfolio generate?

Screen Shot 2013-04-24 at 3.41.34 PM

Let’s use some real historical numbers to do an example. We’ll use Vanguard funds as proxies for the returns.

VPACX is an index fund tracking the Pacific Index (client beta).
NAESX is an index fund tracking US Small caps (your universe)
VISVX is a proxy for your returns (your secret strategy is low P/B!)

Here are the results for 2000-2005:

Screen Shot 2013-04-24 at 3.59.11 PM

Not too shabby, huh? You didn’t beat every single year but clients did get a higher return with lower volatility, and saw a lower blood pressure max drawdown. And you never had to crack a single annual report from some company you’d never heard of in Australia, Hong Kong, Japan, New Zealand, or Singapore.

Even more amazing, your alpha can be ported to any asset class. We added it on top of the Pacific equity beta, but we could just as easily have ported your alpha to an all bonds or even all cash portfolio.

Interested in my eBook about my experiences in the CFA Program?