The conventional approach to building investment portfolios, which relies on the typical hierarchy of investment decisions, imposes constraints on active management. Under most circumstances, these constraints are unnecessary and produce mean-variance inefficient portfolios. By using portable alphas, managers can strike an efficient balance between alpha and beta exposures to create mean variance-efficient portfolios for their clients.
Portfolio managers can take advantage of a new approach to portfolio composition designed to eliminate inefficient constraints by using portable alphas. Portable alphas allow managers to strike an efficient balance between active and passive exposures to create mean-variance efficient portfolios.
There are two potential sources of return and risk in an actively managed portfolio: alpha and beta. Any investment portfolio can be decomposed into an alpha portfolio and a beta portfolio.
One type of return is passive return, or beta, which is the compensation for bearing the systematic risks embedded in each asset class. The beta portfolio is selected by allocating assets based on passive benchmarks. The portfolio of exposures to passive benchmarks is the investor’s beta portfolio, which is sometimes called the “policy portfolio.”
The other type is active return, or alpha, which is expected return earned without bearing systematic risk. This source of risk and return is the away-from-benchmark positions taken by the active manager on behalf of the investor. When all the manager’s alpha-seeking positions are combines, the result is the investor’s alpha portfolio.
Therefore, a given portfolio can be viewed as two sub-portfolios:
- An assortment of benchmark portfolios, generally chosen by the investor (sometimes with the assistance of a consultant), called the beta portfolio
- An assortment of active portfolios, chosen by the investor’s investment managers, collectively called the alpha portfolio
Investment managers can create mean-variance efficient portfolios by taking a modular approach to portfolio construction. First, the structure of the beta sub-portfolio is optimized, and then the structure of the alpha sub-portfolio is optimized. Moreover, the alpha sub-portfolio can often be made self-financing which gives it portability. Due to the mutual independence of the alpha and beta sub-portfolios, they can be combined to create a mean-variance efficient portfolio.
Want to learn how to implement portable alphas into your portfolio construction process? The Windham Portfolio Advisor includes technology to introduce portable alphas to portfolios efficiently and cost effectively, one of the features that sets it apart from the other portfolio and risk management products.