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Tilted Portfolios, Hedge Funds and Portable Alpha

Jul 26th, 2006 | Filed under: Portable Alpha & Alpha/Beta Separation

By: Eugene Fama & Kenneth French
Published: May 2006

This article was written by Fama and French in support of the investment strategies used by Dimensional Fund Advisors, a “passive active” fund manager using various Fama & French models.

It refers to the deconstruction of “tilted” (biased) funds into passive and active components. This process is also discussed in several original articles on this site (particularly “Financial Genomics”, and is also the topic of a white paper in progress). Alpha Male is pleased to see that Fama & French are on the same track

Excerpt:

“We can decompose a tilted portfolio into a combination of the market portfolio and a hedge fund that is long the stocks that are overweighted and short the underweighted stocks. For example, define small stocks as those in the bottom 10% of aggregate market cap, and define Small and Big as value-weight portfolios of all small and big stocks. A client who puts $100,000 in the market portfolio has $10,000 in Small and $90,000 in Big. A tilted portfolio of $15,000 in Small and $85,000 in Big is equivalent to an investment of $100,000 in the market and a hedge portfolio that is long $5,000 in Small and short $5,000 in Big.

“This is a general result. We can always decompose a portfolio into its benchmark plus a hedge portfolio of the deviations from the benchmark.

“Note that the hedge portfolio in our example requires no net investment. The long position in small stocks is financed by shorting big stocks. This is also a general result. Because every extra dollar spent overweighting some stocks in the original portfolio must come from underweighting others, the hedge portfolio that reproduces the original portfolio’s deviations from the market (or any other benchmark) always requires no net investment.”

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