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Friday, July 28, 2006

Average Investors and Portable Alpha

A lot of investors have heard about portable alpha, yet are confused about what it means or how it works. It’s really quite a simple theory, but one that is unfortunately thought to be limited to hedge funds and other investments available for only wealthy investors. I came across this article last night by Scott Patterson of the Wall Street Journal. He outlines the debate regarding portable alpha, explaining the perceived pros and cons of it in the eyes of professional investors. Although he makes some good points, there is another aspect of portable alpha that Scott and a lot of other people don’t address. The fact is that portable alpha can be used by anyone, inside any portfolio, and that investors wanting to invest in it don’t need a hedge fund to do it.

Investors seeking to add alpha to their portfolios can do so in a variety of ways. The most basic method involves investing in a market derivative that provides enough exposure so that the portfolio at least stays on par with the market. Hedge funds use a lot of complicated put / call options and leverage to do this, but that’s not the only method. In fact, average investors can get adequate market exposure by investing in an ETF of a broad-based index, such as IVV, which is an iShare “derivative” correlated to the S&P 500. Granted, iShares such as IVV are not correlated 100% to the S&P 500, and typically trade at lower volume than index mutual funds. But they are much cheaper, which is a crucial component of investing in portable alpha. With adequate exposure to the overall market at a lower cost, investors can then allocate the capital saved by investing in the index derivative into other areas of the market, such as sectors, bonds or specific equities.

So how does the average investor wanting to invest in portable alpha start today? I’m going to answer that question and shift my future posts in this direction instead of focusing on the indicators I use and our allocation recommendations.

Currently, of the eight major markets I analyze each morning, none pass all of the tests in order to be recommended “buys.” Four of them however, are “neutral” rated, meaning they pass about half of the tests, but need more time to strengthen before they can be upgraded. Those three include the NYSE Composite (NYC); the Dow Jones Industrial Average (IYY) and the S&P 500 (IVV). So the first step in investing in portable alpha involves determining the health of the broad-based markets. If you feel comfortable with a specific market and want exposure to it inside your portfolio, look for a derivative that mimics the market, such as an iShare or other ETF.

Taking the market analysis one step further involves style-box investments. Again, there are no “buys” this morning, but the Russell 3000 Growth (IWW) and S&P Large Cap Value (IVE) are rated “neutral.” Assuming you’re comfortable with the overall health of the market (thanks to step #1), the second step in investing in portable alpha consists of determining whether value, growth or all-style equities are out-performing and which market cap.

The third step is determining which sectors are currently outperforming the market. For example, four sectors out of the eighteen that I analyze are rated as “buys” today. These include Real Estate (IYR), Utilities (IDU), Telecommunication (IYZ) and Healthcare (IYH).

At this point, you now have several options. You can invest in the iShare itself of the sector(s) you like. Or you can look for a sector-specific mutual fund. You can also invest in a specific company that falls within the sector(s) you chose.

Here’s an example of how I would set up an investment portfolio based on this mornings analysis. The S&P 500 (IVV) is rated “neutral.” It has a positive, yet low rating score, which means it’s just beginning to develop a bullish trend. It’s not a “buy” yet, but for the sake of argument, I’d allocate 40% of my portfolio to IVV and 20% to the Dow Jones Industrials (IYY), which has a higher alpha score and a more developed trend. That leaves me with 60% of my portfolio allocated to the market in general, and 40% left over to invest in alpha. I’m not too impressed with any of the style-box investments at the moment, so I’m going to look straight at the sectors. Telecommunication (IYZ), Utilities (IDU), Real Estate (IYR) and Healthcare (IYH) are “buy” rated and have relatively newly developed trends. I’d invest 5% of my portfolio in each of those iShares.

So now I have 60% of my portfolio invested in the broad market and 20% invested in four different sectors providing adequate diversification. I have 20% left over to really find the alpha and get some pop into my portfolio.

Century Telephone Enterprises (CTL) was upgraded to a “buy” this morning, so I’d allocate 5% of my portfolio there. In terms of healthcare, Regeneron Pharmaceuticals Inc. (REGN) was also upgraded this morning, which is where another 5% of my allocation goes. This stock is especially interesting since its currently trading below its 200-Day moving average. The energy sector is solid, but natural gas is more attractive to me now than oil. I think the Fidelity Natural Gas fund (FSNGX) is a great way for me to get exposure to energy. Finally, Harmonic Lightwaves (HLIT) gets a 5% allocation not only because it’s a newly upgraded “buy” but because it gives me exposure to the tech sectors, which I don’t yet have.

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