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Portable Alpha - What It Is, Where to Get It, and How to Use It
So much is being written about the emergence of “Quantitative Funds” and why this type of investment is becoming popular among both individual and professional investors. Eleanor Laise, in her Wall Street Journal article titled “Stock-Picker Jobs Going to Computers” wrote that “investors are attracted to quant funds for their non-emotional, disciplined method of investing. It is a well known fact amongst investment professionals that “investor psychology” is the most difficult variable for anyone to manage. Our fear and greed most often get in the way of good judgment and a well thought out investment strategy.” One method of developing a quantitative portfolio includes adding alpha to the investment screening process. Although the idea of alpha is thought to be complicated and only for the technically inclined, it’s available for any investor and now easier than ever to utilize. With this strategy readily accessible, it makes sense to build a portfolio of long-term investments and then augment the return by actively trading a portion of the portfolio using technical analysis and portfolio management.
The real question is not if it can be done, but how can it done. Specifically, how does an investor, be it individual or professional, utilize the power of portable alpha? Before the “how to” can be understood, one must appreciate what alpha is and what investments are available that make utilizing portable alpha easy.
What is Portable Alpha?
According to Lawrence C. Strauss, in his Barron’s Online article titled “Does Low Volatility Mean Lower Returns” alpha “the money-management industry’s buzzword du jour refers to the measure of a stock’s performance beyond what the market provides. But how to calculate Alpha and more importantly how to compare various investment alternatives simultaneously using the same definition of Alpha has been a difficult problem for investors to solve.” Alpha, in its purest sense, is the measure of a fund or portfolio's risk-adjusted return relative to the market. A positive alpha value, such as 1.0, means that the fund or portfolio outperformed the market by 1.0%. The higher the alpha value, the more incremental gain is awarded for actively managing the investment by choosing securities that outperform the market, as compared to merely accepting the market return.
Portable alpha is “portable” because it can be applied across various asset classes. If a manager or individual investor increases a portfolio’s risk-adjusted return relative to the market (alpha) by investing in securities that have little or no correlation with the market, then that manager has created portable alpha. Portable alpha is a powerful investment tool because it can provide investors with greater diversification in their portfolios, lower risks and greater total returns as compared to conventional asset allocation.
There are other varieties of alpha, but in all cases a positive alpha value indicates that the fund or portfolio manager has "beaten the market" through fund or stock selection. Alpha Advisor Service, LLC uses a weighted alpha factor which places more emphasis on recent price movement as opposed to past activity. The purpose of doing so is to pinpoint stocks and funds whose positive momentum is building rather than those that have reached the peak of their uptrend.
Investments That Facilitate Using Portable Alpha
Applying portable alpha to your portfolio can be accomplished by using trade-friendly investment funds provided by ProFunds, Rydex or Fidelity. These companies provide a wide variety of mutual fund selections, including index, sector, bond, precious metals, and international, which can be traded frequently, most without penalty, early trading fee or commission. Some of these companies offer funds designed for hedging strategies. Or for the slightly more aggressive, a few of these companies provide leveraged funds which are designed to outperform their benchmark index through the use of leverage. Exchange Traded Funds, which come in as many styles as mutual funds, also provide an easily-accessible tool for adding alpha to a portfolio.
Many analytical sources provide statistical profiles of investments, most of which are mathematically accurate. The predominant short coming in these tools is that they do not consistently analyze all alternatives. Bond investments will be measured using benchmarks unique to bonds while small cap stocks will be measured against the Russell 2000 etc. To select the best investments, using a level playing field by which to measure portfolio returns is the most attractive.
How to Utilize Portable Alpha
The first step towards utilizing portable alpha involves developing an asset allocation strategy specifically tailored to personal investment objective, risk tolerance and time horizon. Determine how much of the portfolio should be strategically allocated to specific asset classes such as stocks, bonds, sectors, international investments, precious metals and cash. Assign a percentage of investment dollars to each class, and then prepare to fill in the asset class with an appropriate selection of investments.
To select the best investments for each asset class, rank the investments by alpha score from highest to lowest. Then pick the top one or two options for investment within each asset class. Put in place a trailing stop loss on each investment at a reasonable level and watch its performance. If the price violates your watch level, sell the investment and replace it with the next most highly ranked alternative from its class. If no alternatives are available with a positive alpha, hold those dollars in cash until such time as a candidate presents itself. Don’t invest those dollars in another asset class; hold them until a candidate in the particular class becomes available.
This approach satisfies the buy and hold dogma that is unfortunately so engrained in the minds of today’s investors. It supplies adequate diversification while at the same time providing a level of return that’s in line with market expectations. Hopefully, by this point recent market activity has convinced most investors that the idea of buying a stock or fund and holding it indefinitely is no longer the optimal investment strategy. Human nature has a tendency to result in buying and selling at the worst possible moments, minimizing gains and maximizing losses. That’s why the development and implementation of a disciplined investment strategy is so advantageous to today’s investors.
Taking this approach one step further and evolving from a strategic allocation to a tactical or dynamic allocation is the easiest way to generate excess investment returns within a buy and hold strategy. Tactical allocation is predicated on the belief that not all asset classes perform in the same manner and that investment cycles do exist. With so many index funds and ETF’s that mimic the performance of market indices and style-box investments, analyzing the alpha scores of these investments is the quickest way to determine where to increase or decrease a portfolio’s allocations.
Today, with so many internet-based trading platforms available through brokerage firms and banks with minimum fees and almost no trading commissions, active personal investing makes more sense then ever. Affordable high-speed internet connectivity, computers, cell phones and internet brokerage accounts coupled with powerful mathematical statistics such as portable alpha are negating any excuses for experiencing unacceptable investment returns.