An Alpha Unleashed: Optimal Derivative Portfolios for Portable Alpha Strategies

Abstract

In the past few years there has been an increasing interest in so-called portable alpha strategies for institutional investors. In a nutshell, these strategies aim at isolating the contribution above the benchmark return (alpha) in a given investment, and to potentially port it on to another, more desirable benchmark (or beta). In its most extreme form this would allow institutional investors to fully de-couple their asset allocation from the manager selection, and to enjoy the best of both worlds: they could match their asset allocation to their liabilities, while continuing to source their alpha from the highest-alpha strategies available to them. In short, alpha has been unleashed. Such an approach raises a host of very practical questions related to the derivatives employed in stripping the underlying beta off of the alpha-generating strategies. For a given investor, what is alpha, and what is beta? For a given strategy, what is the actual exposure to the betas the investor cares about? For a given exposure, what derivative portfolio offers the most efficient beta-stripping solution? And, once the approach has been implemented, how can we verify ex-post whether the approach chosen has added or destroyed value? This article discusses these questions in detail, and then proceeds to suggest a concrete, implementable framework that aims to resolve them.