by Eugene F. Fama and Kenneth R. French
Portable alpha is the return from an active investment strategy that has no exposure to some index, such as the S&P 500 or the Russell 2000. It is often sold as a way to get the benefits of active management at lower cost. For the moment we leave aside whether there are benefits to active management and focus on the claim about costs.
To keep things simple, suppose an active manager has a market beta of 1.0, overweighting some stocks relative to the market portfolio and underweighting others. The manager’s return can be represented as the sum of a market component, M, and an active management component. The active management piece is the manager’s alpha, α, plus a random error, ε, that arises because the difference between the manager’s return and the market is not certain. The active manager’s portfolio return, P, is,
(1) P = M + (α + ε).
Suppose a portable alpha (PA) manager comes along and claims there is a way to get the active manager’s return, P, at lower cost. Specifically, the investor is to buy a low fee index fund that provides M, and the PA manager does financial engineering to replicate the active component of P, that is, (α + ε).
One version of the PA financial engineering involves shorting the market portfolio, promising to pay the return M per unit of borrowing, and using the proceeds to buy the active portfolio that generates P. In a world with no short selling costs and full use of the proceeds from the short sale, the net return from the financial engineering is P – M = (α + ε), which along with the return M on the investor’s index portfolio, indeed replicates the return P of the portfolio of the long only active manager.
In this simplified scenario, the investor puts no money into the PA end of the strategy at the beginning of the year and gets the net return α + ε at the end of each year. The return is positive when the actively managed portfolio does better than the market (α + ε > 0) and negative when it does worse (α + ε < 0). In the latter case the investor must use part of the payoff from the index portfolio to cover the loss. This is portable alpha in the purest sense.
In the real world there are costs at every step of the PA approach to generating the active return P. Like the long only active manager, the PA manager holds the active portfolio that generates P and so has the costs associated with identifying and producing this portfolio. The marginal costs of the PA strategy are (i) Index Costs – the fees and expenses of the index portfolio that provides M, plus (ii) Shorting Costs – the PA manager’s costs of shorting M, plus (iii) PA Fees – the fees charged by the PA manager. The marginal benefit is the Active Fees that are avoided. The PA strategy will be lower cost to the investor if,
(2) PA Fees + Index Costs + Shorting Costs < Active Fees.
In short, the PA strategy is a lower cost route to active management when the fees of the PA manager are below the fees of the long only active manager by more than enough to cover the sum of the costs of the index portfolio and the costs of shorting the market.
When the PA manager cuts fees by enough to ensure that (2) holds, PA is a good deal for the investor, but there is a more attractive route for the PA manager. To produce the active portfolio with return P, the PA manager replicates the costs of the long only active manager and generates the additional costs of the other steps of the PA strategy. To make the PA product attractive to the investor, the PA manager must charge fees sufficiently below those of the long only active manager to cover the additional costs of the PA strategy. The PA manager would be better off and the investor would be no worse off if the PA manager drops the veil of useless financial engineering that generates the additional costs and just offers a long only active portfolio with fees lower than those of the competing active manager.
There are many variants of the PA strategy that differ in detail from the highly simplified approach discussed above. For example it may be cheaper for the PA manager to short the market by taking the short end of a futures contract on the market index. All the alternative approaches are generically similar in the sense that the financial engineering of the PA strategy involves costs in replicating the active return beyond those of a simple long only approach. And to make the PA strategy work for investors, the fees of the PA manager must be lower than those of a long only active manager by enough to cover the extra costs of the PA strategy. It is up to the investor to check that this is actually true.
Cost is not the only purported advantage of PA strategies. Some investors, for example, use them to combine active management in one asset class with passive investing in another. Our fundamental skepticism about portable alpha strategies, however, is quite general. Based on many papers in the academic literature and our own work on mutual funds (Fama and French 2010), we think identifying active managers likely to deliver positive alpha after fees and expenses is a near-impossible task. For more on this you may want to read the executive summary of our mutual fund paper.
Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.