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Portable Alpha


Leverage simply increases risk!


Editor's Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.

I have read about "portable alpha" being the latest great thing in the institutional world. If I understand it correctly, institutions are leveraging lower return assets like cash by using it as collateral to fund derivatives-based alpha strategies performed by third parties. Am I in the ballpark with this and if so is it yet another form of expanding leverage that is in the system?

The whole thing sounds a bit ridiculous to me, as by definition alpha is a zero sum game in total - hardly a systemic windfall for our pension problems.


Minyan James


I am sure we are going to get some responses from people on this one, but this is how I view alpha and beta.

First of all, this is all linear and therefore backward looking. So the alphas and the betas are constantly changing, updated by new empirical evidence. What I am trying to say is that there is little predictive value in these measures, although the great sales machine (GSMW) called Wall Street plays these cards to impress clients.

Alpha is the intercept of the Security Market Line (SML) of the CAPM model, a model that attempts to describe the behavior of individual assets against its universe (either the market or related assets). The SML is a regression line (best fit) through data of an asset's prices versus its benchmark. Alpha is where the asset "begins" in performance against this benchmark; it is the "fixed" amount of outperformance expected based on past performance. But this alpha is constantly re-adjusted as the asset outperforms or underperforms, so to call it fixed is incomplete. If we imagine a world with fixed alpha we should all be rich.

As you state, the alpha for the universe itself is zero (the average of all the alphas) by definition. I would also say (and you indirectly did too) that the average alpha for any asset over long periods should be zero as well: an asset cannot be expected to always outperform its peers. Microsoft (MSFT) did for a long time, but doesn't anymore.

Beta is the slope of the SML for an asset. So from a fixed beginning of alpha "outperformance" the slope of the SML will show how much that asset will go up or down relative to a move in the benchmark. Some people use beta as a volatility number, although that is a little crude.

As you state, there is no way to increase the alpha for certain because the alpha changes over time and averages zero over long periods of time. If you use leverage on an asset that has a positive historical alpha, you may be increasing alpha for a period (although you won't know yet), but are really leveraging the beta, for you are increasing the downside as well as the upside. There is no free lunch.

So no matter what the GSMW calls it, leverage simply increases risk.

When the State of Illinois Pension issues bonds and uses the proceeds to buy stocks they may or may not be "increasing" alpha (as it is not predictable), but they certainly are leveraging beta.

Prof Succo

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