Example of Portable Alpha
As an example, consider a manager who invests only in small-cap US stocks, and the stocks in his portfolio have an average beta of 0.85. In a bear-market year, his portfolio returned 5% less than a risk-free asset, while the small-cap US stock market (the Russell 2000) declined 10% below the risk-free rate. Based on his beta (market risk), his portfolio should have returned 8.5% less than the risk free asset, but his skill in picking small-cap stocks resulted in his portfolio only declining 5% below the risk-free rate. The difference between 8.5% and 5% is attributed to skill and called alpha. So his alpha for this year would be 3.5%.
To make this 3.5% alpha "portable," the manager could have sold Russell 2000 index futures at the beginning of the year, hedging out his exposure to the market. An investor in this type of portfolio would experience a return, not of 5% less than that of the risk free asset, but a 3.5% above that of the risk free asset.
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