If you watch CNBC or read some of the financial journals, you've probably stumbled across the word alpha. Most non-institutional investors don't know what it means but they should since the attainment of alpha is the goal of every investor, whether he or she realizes it or not. So what is alpha? Alpha is nothing more than the excess return of a stock, portfolio, or fund over a given benchmark. I won't bore you with the mathematical equation for alpha, but it takes into account the price risk, or volatility of the stock or fund and compares its risk-adjusted performance to a benchmark, usually the S&P 500. The price risk is given by a coefficient named beta. Sometimes you'll see the beta of a stock listed under the company's profile. Beta is a measure of a stock price's volatility as compared with the overall market. Since the S&P is the typical benchmark, it has a beta of 1. A beta of 2.50 represents price movement that is 150% more volatile than the market; a beta of 0.50 represents a movement that is half as volatile as the market. Beta can be viewed as a measure of risk so that riskier stocks such as high-tech stocks typically have beta's greater than 1 while less risky stocks like utilities have betas less than 1. With me so far? Good.
Now let's get back to alpha. In the hedge fund world, alpha is of primary importance. Hedge fund managers are rated according to how much alpha their fund generates. (They're also rated according to their Sharpe ratio which is defined below.) A positive alpha of 1.0 means that the fund outperformed its benchmark index by 1%, and a negative alpha of -1.0 means that it underperfomed it by 1%. Alpha can be viewed as a measure of the fund manager's ability to generate profits in excess of market returns. This isn't that easy to do and sometimes the process of seeking alpha requires taking substantial risks which is why a lot of hedge funds that have invested heavily in mortgage-backed debt are in serious trouble right now.
Fund managers are usually paid in accordance to how much alpha their fund generates. The higher the alpha, the higher their fees (usually). Hedge fund managers with stellar alphas and high Sharpe ratios can take up to 50% of the profits! That's why many of them have homes in the Hamptons worth tens of millions of dollars, bid up oil paintings to ridiculous prices at Sotheby's, and flitter to and fro on private jets. But hey, if you're a high net worth individual with money in their funds, you're probably hob-nobbing with them, too.
If you're not a part of the jet-set, is there a way that an individual investor can increase alpha without increasing portfolio risk? Yes, via the theory known as “portable alpha.” In essence what this means is that an investor would invest some of his portfolio in securities (or other instruments) that have no correlation with the existing portfolio. (They're separating beta from alpha.) This typically involves leveraging part of the portolio using futures. I know that most people shy away from futures, but it's not as formidable as it sounds. Really. Let's look at an example.
Adding Alpha without Adding Risk
Let's say you have a portfolio of $200,000 invested in Treasury bonds (which are essentially risk-free) that are currently yielding 4%. You're not happy with that rate of return and would like to increase it without adding risk. You think that although the S&P has been lousy, things might be looking up and you'd like to invest 30% of your portfolio into the index. You believe that a 10% return on the S&P for this year is reasonable, if not even a bit conservative. So, instead of investing $60,000 into an S&P index fund, a better approach is to buy $60,000 worth of the S&P Emini futures. Although margin requirements for buying futures varies among brokers, we'll use 10% here. (My broker charges about 7%.) What this means is that you'll only need $6000 to buy the futures. So what do you do with the leftover $54,000? You buy more treasuries.
These leaves us now with a portfolio of $194,000 in treasuries and $6000 allocated to margin for the futures. At the end of the year assuming everything works out as planned, your rate of return will be 6.9% instead of 4% had you only owned treasuries. (4% x $194000 + 10% x $60000) You've increased your return by nearly 3% without adding portfolio risk. (Actually, your return will be slightly less since there's a built-in premium to futures contracts.)
However, you do take on another risk--that of event risk. If the stock market takes a nasty drop, you might be faced with a margin call in your futures account. In the event that this happens, you'll need to deposit more money into your margin account. To do this will require you selling some of your T-bonds to make up the difference. If the market corrects and you have now excess capital in your margin account, you can reinvest that into treasuries. Your new projected rate of return will be different and probably less than expected depending on the going T-bill rates.
That's it for the example. I want to emphasize that I've only scratched the surface on the discussion of alpha and beta. People have won Nobel prizes developing these concepts, so take heart if you don't quite understand them, but be assured that institutions do.
Portable alpha is used regularly by fund managers to add alpha to their funds without increasing risk. They do this by using futures to generate money that they can use to purchase other instruments they feel will generate positive returns, thus increasing alpha. And now, so can you!
The Sharpe Ratio
The Sharpe ratio is a measure of risk-adjusted return. Essentially, the Sharpe ratio tells us whether returns are due to smart investment decisions or are a result of excess risk. The higher the ratio, the safer the strategy. (Sharpe ratios greater than one are considered to be good.) It can viewed as a measure of the fund manager's consistency. Two funds may have the same alpha, but the one with the higher Sharpe ratio has better risk-adjusted performance. If you're comparing funds with similar focus and performance, look at their Sharpe ratios. The ones with the highest ratios will be the safer investments, although past performance is no guarantee of future results...