I know what you did last summer…you wrote a paper lambasting portable alpha
Dec 13th, 2006 | Filed under: Portable Alpha & Alpha/Beta Separation“Inefficiencies of Portable Alpha Models”
By: Eric Murphy, Princeton University
Published: July 29, 2006
Ah, those hazy lazy days of your college summers. Summer jobs, parties, weekends at the beach, writing portable alpha research papers.
Princeton undergraduate student Eric Murphy did just this, finishing off his clearly worded, logical argument against portable alpha in the dog days of last summer. In the paper, he makes two central arguments:
“…the portable alpha technique is nothing more than borrowing money and investing in hedge funds or funds of funds.”
“…the practice of separating alpha, and making it portable, creates further inefficiencies when the investor holds a diversified portfolio.”
Portable Alpha: Just borrowing to invest
Murphy uses a simple “no arbitrage” model to illustrate how an unfunded beta position plus a fully funded alpha position is analogous to “borrowing money and investing in hedge funds”.
“It is easy to see the portable alpha does not provide any special advantages; it only works as a means of hiding the additional risks of investing in volatile hedge funds with borrowed money. In fact, by creating the exposure using derivatives, there is a loss of efficiency due to the spreads on the derivative, tracking errors, and transaction costs.”
Portable Alpha: Inefficient to be both long and short the same names
He then draws on Eugene Fama and Kenneth French’s argument that it’s more efficient to simply not own a certain stock than it is to buy it embedded in an active fund only to short it out again in an effort to isolate alpha.
“In this situation there are likely to be many overlapping stocks from the original short selection and the S&P 500. By both longing and shorting the stock, the investor creates a position that has no net investment. This is inefficient for the investor since the cost of shorting is completely wasted.”
Portable Alpha: But That’s Not the Point
But in our view, this paper established “efficiency” as a straw-man argument for portable alpha, then succinctly attacks it. In reality, portable alpha is about flexibility and choice in portfolio construction. It’s about not having to buy alpha and beta bundled together in one-size-fits-all proportions. This is critical not because it performs better in the “straight aways”, but because it “hugs the curves” of each investor’s mandate or portfolio.
If an investor has a mandate to own 75% S&P 500 beta and 25% alpha, she may only have a few active management options from which to choose. But by separating alpha and beta, she is able to select any alpha source and adjust its beta exposure to meet that of her mandate. This may require the addition of more beta or the shorting out of some (or all) the beta. The inefficiencies created are a small price to pay for this flexibility. This paper by Morgan Stanley’s portable alpha group makes the point well.
The bottom line is that messing around with alpha and beta obviously creates friction costs. So when compared to long-only portfolios ceteris paribus, they will naturally be less efficient. But portable alpha investors are the first to acknowledge that simply porting alpha doesn’t increase it. That’s not why they invest. Instead, they use the strategy to broaden their opportunity sets and aid in portfolio construction.
Murphy’s paper is clear and well written, but is too quick to rain on portable alpha. Maybe he was just bitter about spending his summer stuck inside writing a white paper.
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