Overlay Speak
Sep 27th, 2006 | Filed under: Portable Alpha & Alpha/Beta SeparationBy: Lex Huberts, Standish Mellon Asset Management
Published: Fall 2004, Journal of Investing
This paper does an excellent job of covering the many flavours of alpha-centric investing. It also provides a number of hypothetical mathematical examples of portable alpha. Including the following:
“Suppose a plan has a very talented Japanese stock selector who is considered very likely to outperform the local market. What if the plan likes the manager’s skill, but is leery about the prospects for Japanese equities in general? To reduce risk or to express a negative opinion on the Japanese equity market, derivatives can be used to eliminate the systematic equity or currency exposures through the short sale of futures and forwards. Currency hedging programs are more common, but the equity exposure may be eliminated just as easily.”
Importantly, Huberts does not necessarily advocate the use of market neutral hedge funds per se. Instead, he positions hedge funds as simply a subset of portable alpha. He suggests that an “absolute return” manager need only short their benchmark to earn that designation. Of course, doing so provides no potential for alpha from short positions. So he introduces hedge funds as one possibility…
“Long-short equity strategies are fully funded accounts that invest in equities but also borrow and sell (short) other physical equities. If the long positions are equal in size to the borrowed position, there is no systematic equity market exposure. This is another incarnation of the absolute return concept.”
But back to the Japanese long-only manager who simply shorted the Nikkei. Huberts shows how the resulting alpha can be “transported to the S&P500…
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