Sorry I know this has been asked before (here & here) but I don’t feel comfortable with my understanding.
Taken from 7.3 in CFAI Volume 4 - Fixed Income and Equity Portfolio Management.
“Assume that an investor desires S&P 500 market exposure but has identified a capable active manager of Japanese equities benchmarked to the TOPIX index. The investor can port the manager’s alpha by taking a short futures position in TOPIX and a corresponding long position in S&P 500 futures. The resulting portfolio is S&P 500 plus an alpha associated with the Japanese equity portfolio.”
Questions:
Are we assuming we invested with the active manager of Japanese equities? That would make sense to me as combining that with a short futures position of TOPIX would eliminate beta and leave me with alpha.
Is alpha and beta separation the same as portable alpha? If not what is the difference?
The Japanese manager is benchmarked to TOPIX but your aim is to utilize the manager for alpha so you go short TOPIX futures to eliminate the beta risk. The long S&P500 futures nets you the US beta, the Japanese manager and short TOPIX the alpha.
If the question had stated the Japanese manager is pursuing a long/short strategy you wouldn’t be required to short TOPIX anymore.
Portable alpha is basically the application of alpha and beta separation, i.e. gain beta exposure via derivatives and allocate to alpha wherever there are market inefficiencies.
Let’s say you are a fund manager and in your mandate you decide you want Beta exposure in USA but like the look of Japan and want some return there too.
The first thing you do is decide what you want beta from. In this case, its USA, So S&P.
Now you look at Japan. You like Japanese equities and want exposure but wait, you already have beta exposure in USA. Your mandate says you can’t take on more beta exposure. You would be doing that if you bought Japanese futures and therefore increasing risk as you have double beta exposure (USA and Japan)
So what do you do? You say, OK - I want the Japanese exposure but JUST the skill of the manager and no beta exposure. (I already have that in America)
OK, how do I do that? Well… I go Long a Japanese equity manager who can select good stocks. But the Japanese manager will have Beta too which you dont want. So at the same time you short the japaense futures market.
Whats the net impact. You get beta in America. You get Alpha in Japan. And you cut all the Beta out of Japan too. The result is a portable alpha strategy where you have got equity beta in America and equity Alpha in Japan without doubling the beta.
Yes it’s a manager that manages a portfolio against TOPIX so he will hold long positions based on views on the benchmark’s securities (Japanese equities), so that’s where your physical cash is invested at.