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Tuesday, July 18, 2006

What Exactly is Portable Alpha?

In order to understand “alpha,” investors need to understand the concept of “beta” and how the two are related. When people choose to invest, they are accepting the fact that investments are subject to two forms of risk, systematic and unsystematic risk. Systematic risk, also known as market risk, is the risk inherent in the entire market and cannot be avoided by diversification. Interest rates, recession and wars are examples of sources of systematic risk. Unsystematic risk only applies to a small portion of the market such as a specific stock, or even a sector.

Beta is simply a measure of an investment’s systematic risk, or volatility, compared to the market. If a security has a beta value of 1.0, the price of the security will move with the same volatility as the market. A beta value greater than 1.0 means the price of the security it more volatile than the market. Conversely, a beta value less than 1.0 indicates that the price of the security is less volatile than the market. Beta is another way to describe investment returns resulting from passive exposure to the overall market.

Alpha, in its purest sense, is the measure of a fund or portfolio's risk-adjusted return relative to the market. A positive alpha value, such as 1.0, means that the fund or portfolio outperformed the market by 1.0%. The higher the alpha value, the more incremental gain is awarded for actively managing the investment by choosing securities that outperform the market, as compared to merely accepting the market return.

Portable alpha is “portable” because it can be applied across various asset classes. If a manager increases a portfolio’s risk-adjusted return relative to the market (alpha) by investing in securities that have little or no correlation with the market, then that manager has created portable alpha. Portable alpha is a powerful investment tool because is can provide investors with greater diversification in their portfolios, lower risks and greater total returns when used in conjunction with conventional asset allocation.

There are other varieties of alpha, but in all cases a positive alpha value indicates that the fund or portfolio manager has "beaten the market" through fund or stock selection. Alpha Advisor Service, LLC uses a weighted alpha factor which places more emphasis on recent price movement as opposed to past activity. The purpose of doing so is to pinpoint stocks and funds whose positive momentum is building rather than those that have reached the peak of their uptrend.

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