If you are in the institutional investment business, you have likely heard the name “AP3” before.  The SEK $228 billion (US$32 billion) fund announced in May that it would manage its alpha and beta portfolios separately from now on.  According to AP3, “(The) fund’s aim by separating alpha and beta is to make the portfolio structure more flexible, improved risk diversification and higher cost efficiency in order to increase the potential return.”

Erik Valtonen, CIO of AP3, will reflect on the fund’s experience later this week at an industry gathering in Hong Kong.  But today in this AllAboutAlpha.com exclusive, Valtonen tells us why portable alpha has both “merits and risks”. 

Special guest contribution by: Erik Valtonen, Chief Investment Officer, AP3

Portable alpha is certainly a concept that has quickly made an entry to the every investment professional’s vocabulary. Even smaller investment managers are now talking about the merits of porting alpha. In this brief note I make a short summary of the concept, and highlight some of its merits and risks.

Alpha and beta

Return streams are traditionally divided into beta and alpha components, although it seems to be difficult to define exactly what these labels are. Obviously, the origin of the labels lays within the CAPM, where beta is a measure of the exposure to market risk and alpha is the intercept. In this spirit, beta can be defined as the return that is gained by a passive exposure to some risk premium. Traditionally, these exposures include equity and bond markets but recent years have seen the birth (or rather recognition) of a plethora of ‘alternative betas’ ranging from small cap premium to liquidity. Alpha, on the other, could be defined as that part of the return stream that is not explained by beta . To add positive alpha the manager needs to exhibit skill (or luck) either by securities selection or by timing.

Ability to allocate between different beta factors will produce alpha, so the distinction between alpha and beta is not always clear cut, and will depend on the time horizon where the returns are viewed. As an example, a GTAA manager will typically allocate his risk budget between various beta sources. At any point of time the manager will have different beta-exposures but these are not static but are managed dynamically. The manager’s skill exhibits in his ability to find the right mix of beta exposures.

More…