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Is the latest Wall Street investment management craze fact or fiction? The Wall Street Journal took a look at the how pension funds are employing a concept called “portable alpha” as an alternative to using mutual funds to invest in the market.
Portable alpha allows investors to buy contracts of a derivative that tracks a market index. Because these contracts are not costly, the freed-up cash can then be invested in hedge funds and other investment options. The returns from these alternative investments represent the “alpha”, or better returns than a benchmark used by the manager. The “portable” part refers to the addition of the alpha to the benchmark (beta) boosting returns.
At the heart of the concept is the belief that numerous managers can beat the market on a regular basis over time. From an academic point of view, the Journal notes, that idea is “widely disputed.” And who better to speak to that issue than Eugene Fama, who’s strongly identified with research in the stock market, particularly the efficient market hypothesis.
A recently published paper by Fama and Kenneth French is cited by the Journal as explaining why portable alpha won’t work. The paper discusses that because the strategy depends so much on borrowed funds, it is very likely to sustain sharp losses when the market faces tough times.
If you wish to learn more, the article ran in the Wall Street Journal on June 29, 2006.
Read a copy of the paper that discusses portable alpha.