P O R TA B L E A L P H A R O U N D TA B L E

Portable Alpha:
Mark Carhart, GSAM
Process, Cost and Risk
On October 27, senior executives met for a discussion of the portable alpha investment
strategy at Alpha’s offices in New York. Participating were Mark Carhart, managing director,
co-chief investment officer and co-head of Quantitative Strategies, Goldman Sachs Asset
Management; Kent Clark, chief investment officer and co-head of Hedge Fund Strategies,
Goldman Sachs Asset Management; Joseph Gieger, managing director, GAM; Jim Haskel,
director-portfolio strategy, Bridgewater Associates; Yoshiki Ohmura, head of portable
alpha strategies, GAM; and Bob Prince, co-chief investment officer, Bridgewater Associates.
Marilen Cawad, news editor of Special Projects for Alpha served as moderator.

Kent Clark, GSAM Moderator: What is portable alpha and how is it
different from hedge funds and traditional active
management?
Kent Clark, Goldman Sachs Asset Management:
Portable alpha is very straightforward. The idea
is to take the active risk and return that is gener-
ated by an active manager, and move it from
whatever asset class or field of expertise the
manager has onto the benchmark of choice.
There is not a lot of difference between portable
Joseph Gieger, GAM alpha and hedge funds and traditional active
management. Each manager has a single set of
views that lead to a single optimal portfolio. The
question is where an investor wants that set of
views, and that alpha, placed. If it’s in a tradi-
tional active management context, then you
have constraints, for example on asset classes,
benchmark membership, and short selling. Take
the same views and put them into a hedge fund
context and they are unconstrained. The benefit
of portable alpha is that it takes unconstrained
Jim Haskel positions resulting from the manager’s views
Bridgewater Associates and overlays them with a benchmark of choice.
management. All three of those can be
portable. In other words, the portable part is
the action that you take to engineer the port-
folio: to take a given alpha and reposition it
someplace else. Alpha overlay is one form of
portable alpha. It is the process of literally
creating an alpha from scratch, disassociated
from any underlying assets.
Moderator: Is there an investment size require-
ment to do portable alpha?
Mark Carhart, Goldman Sachs Asset
Management: Many managers have created
portable alpha vehicles benchmarked to the
most common asset classes and the minimum
investment sizes are small. But to do a more
complex, customized portable alpha program,
you have to think about an investment portfolio
that is larger, in the order of hundreds of mil-
lions of dollars or more.
Moderator: How would you describe the growth
in portable alpha?

Joseph Gieger, GAM: It's simply a technique
where someone can enhance the returns above
and beyond the index of choice. If a client
were to look toward a Lehman Aggregate bond
index or an S&P 500 equity index, he would be
able to assure himself of at least the return of
that particular index. Above and beyond that,
he's looking to add additional uncorrelated
Yoshiki Ohmura, GAM return to that benchmark, which we call alpha.
He would then couple or port that return with
the index of choice and thereby create a
portable alpha solution.
Bob Prince, Bridgewater Associates: Different
people use language differently. The way we
think about it is that there's alpha overlay, there
are hedge funds, and then there's traditional
Gieger: We continue to see strong demand
from institutional clients. Primarily driving it
is the fact that they can keep their existing
asset allocation, i.e., X percent in equities, Y
percent in bonds, intact while at the same time
adding a return from funds of hedge funds
above and beyond what traditional approaches
are able to offer. This simplicity, that is not
having to change your overall asset allocation,
has contributed to portable alpha’s attractive-
ness and growth.
Clark: For many investors, taking alpha and beta
separately as risk sources and return sources is
still a relatively new concept. If you look at a
typical asset allocation for an institution, even if
every dollar allocated from that institution is

This Sponsored Roundtable was prepared by the Special Projects Department of Alpha
Bob Prince
Bridgewater Associates
Alpha Sponsored Roundtable • November/December 2006 • 1
P O R TA B L E A L P H A R O U N D TA B L E
actively managed in a traditional way, the lion’s share of the risk
comes, first of all, from passive equity exposure, secondly, from
passive fixed income exposure, and then just a small part of the
overall risk budget is from alpha sources. So there's huge room
to increase the amount of alpha, and portable alpha is one way of
essentially having your beta cake and eating the alpha, too.
Moderator: What’s the difference between bundled and unbun-
dled solutions?
Yoshiki Ohmura, GAM: When we speak of bundled solutions, we
are primarily referring to a fund or other legal structure that mul-
tiple clients can invest in and is typically managed by one manag-
er. It could also be a bank-issued security where all the assets of
those clients are managed on a commingled basis by the manag-
er. In unbundled solutions, clients are running the alpha and beta
overlays individually on their own balance sheets, usually using
two separate managers.
Moderator: Which solution is better suited for institutional
clients?
Ohmura: We think that most clients are better suited in a bun-
dled solution. The big advantage is that it's a one-line item
accounting entry. Additionally, the product provider manages the
operational and legal aspects of the derivatives portfolio, making
it very easy for clients to handle. At the same time, there is lever-
age in portable alpha. So in a bundled solution, that leverage is
non-recourse, i.e., the client’s losses are limited to what they
invested in that legal structure. Whereas, if they are running an
unbundled solution, not only is there risk on the amount invested
in the alpha source, but at the same time, the client is fully liable
on the derivatives portfolio.
Jim Haskel, Bridgewater Associates: It's important to note that
right now there are some big institutional pension funds that are
actually organizing themselves around the unbundled principle.
For example, there are two big pension funds in Europe, one in
Denmark and one in Holland, that are organized now with a beta
department and an alpha department, which seems to us to be
the right way to go about it. That started in Europe, and I know
they’re starting that here in the US. And once you get to that
point, then you truly are in an unbundled world, and it seems to
Bob Prince, Bridgewater Associates: “Whether you produce
returns from alpha is entirely the function of your own ability.”
2 • Alpha Sponsored Roundtable • November/December 2006
Joseph Gieger, GAM: “We continue to see strong demand
from institutional clients.”
me a better world than what we're currently in now where we're
trying to fit things in order to get the advantages of breaking
apart alpha and beta, but doing it in a sort of a chaotic way where
it's the equity department, the fixed income department over a
bond or an equity benchmark.
Carhart: One of the advantages of portable alpha is that you
aren’t compelled to take as much beta risk as you would in a
traditional product. Therefore, there’s the opportunity to produce
investment products with higher Sharpe ratios by shifting risk
from beta to alpha because the return per unit of risk on beta is a
lot lower than a good alpha source. We're seeing many clients ask
us as asset managers to take a stand on the proportion between
beta and alpha and even choices of strategies within an aggregate
beta and alpha portfolio. So it’s all about looking for an optimal,
maximum, Sharpe ratio portfolio.
Moderator: What are the key considerations in selecting the
alpha and beta components?
Prince: When we look at any portfolio, we break it down into
three parts. You’ve got the risk-free rate; the beta, which is the
return that's derived from systematic risk; and alpha, which is
the return over and above the beta that's generated by manag-
er skill. The fundamental difference between beta and alpha is
that everybody in the world could invest in a certain type of
asset, and everybody in the world could earn that excess
return from the risk premium. But alpha is a zero sum game.
So if everybody in the world is doing alpha, on average they all
break even, minus transaction costs. With beta, you can be
more confident that if you wait long enough, you will outper-
form the risk-free rate. With alpha, you never know if you will.
Whether you produce returns from alpha is entirely the func-
tion of your own ability to either make market bets or pick peo-
ple who know how to make market bets.
Carhart: We think that attractive alpha strategies should have the
following features, which we refer to as the 5 C’s: high consisten-
cy; low correlation; capacity to sustain the high information ratio;
capital efficiency; and low implementation costs. Consistency
means how high the return is per unit of risk, typically measured
in the information ratio of the strategy. Correlation refers to how
the strategy relates to your existing portfolio. Capacity is fairly
GSAM Ad QS 10_06 11/15/06 4:31 PM Page 1

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P O R TA B L E A L P H A R O U N D TA B L E
obvious, since many high information ratio strategies have rela-
tively small investment sizes, limiting the impact on your portfo-
lio. Capital efficiency is not as well appreciated and refers to how
many dollars of alpha are achieved per dollar contributed to the
strategy. Clients with a large indexed allocation might not care as
much about capital efficiency, but most investors are much more
capital constrained than risk constrained. And finally costs,
which include not only management fees but also implementation
costs, which can be significant in less liquid strategies. You can
essentially rank strategies on these 5 C's to come up with the
ones that are most attractive for each investor.
Haskel: The problem is that there are not a lot of managers who
actually do that very well. And those managers who do that very
well tend to be at capacity. At the end of the day, alpha is about
skill. When I talk to clients about what they expect from their
active management, it's notoriously high information ratios
across the board. Of course, they wouldn't say it's low informa-
tion ratios because otherwise what's the use of having alpha in
your portfolio? But about half of them are going be right and half
are going be wrong. So having that confidence in the five C's is
good, but that confidence should be humbled a little bit.
Ohmura: In terms of risk and volatility, there is usually a lot more
risk in the beta component than in the alpha piece. So if you get
that piece wrong from the structural side, you could do a lot
more damage to your product than the alpha side could compen-
sate for. When building a portable alpha solution, one has to be
very cognizant about the characteristics of each individual com-
ponent, how those individual pieces are managed and how they
work together. There are many different ways of implementing
portable alpha and a lot of investors are not spending enough
time looking underneath the hood to see for themselves how the
actual solutions work.
Haskel: The reality of it is that there are a lot of efficiency gains
you can get in beta that aren't yet being taken advantage of,
through leveraging types of techniques that equalize risk and
return of asset classes and create more diversified asset alloca-
tions that are currently equity dominated. Those haven't yet been
pushed by the whole industry, in part, because either they
haven't thought about it or, more importantly, they have been
focused on where the highest fees are, which is alpha.
Mark Carhart, GSAM: “It’s all about looking for an
optimal, maximum, Sharpe ratio portfolio.”
4 • Alpha Sponsored Roundtable • November/December 2006
Jim Haskel, Bridgewater Associates: “I see a world in which
fees are going to be much more discriminating.”
Prince: Alpha overlay managers and hedge funds have structural
advantages over traditional alpha generators. They have a
greater breadth of choices; they can go long and short. They can
have more latitude to create more diversification in the portfolio,
and with more diversification they can produce more consistent
returns. As a result, they have been more successful at producing
alpha than traditional managers. Their fees are higher but if tra-
ditional managers are generating negative alpha and charging fees
for it, that's actually a lot higher fee than a manager who's pro-
ducing a positive alpha and charging a portion of that.
Haskel: As tools become available, investors can look through
their hedge funds and absolute return strategies, and identify
which ones are truly offering alpha beyond either cash or any
embedded beta and are uncorrelated. I see a world in which fees
are going to be much more discriminating, where those types of
managers are going get the highest fees and the ones that aren't
providing any value are no longer going to be able to charge
those fees because they'll be spotted out.
Moderator: Why is portable alpha an attractive strategy now?
Carhart: People want to get more alpha into their portfolio. They
also want to have the right betas in their portfolio and the right
combination of alpha and beta. Another reason is the significant
growth of the derivatives market. In order to transport the alpha,
you need to access derivative instruments that require small
amounts of initial capital to obtain larger exposures and are also
liquid enough to easily adjust the beta.
Ohmura: In general, institutional investors’ behavior can be attrib-
uted to circumstance. Currently many pension funds are under-
funded, so a solution offering potential outperformance over the
traditional asset allocation approach can be very appealing. This
is similar to the recent increase in liability driven investing (LDI)
popularity. In certain countries such as the UK and the
Netherlands, regulation changed recently, requiring pension funds
to mark liabilities to market. So even though there hasn’t been a
change in their liability structure, the change in regulation has been
the catalyst for the change in how those liabilities are managed.
Moderator: What are the risks associated with managing
portable alpha?
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P O R TA B L E A L P H A R O U N D TA B L E
Ohmura: When we're implementing portable alpha strategies,
we’re replicating the beta through a derivatives market. That
could be forwards, futures, swaps, even options, and the
alpha pieces are simply a direct investment in a portfolio of
hedge funds or in a fund of hedge funds. Just from that frame-
work, there's inherent leverage in the strategy, so the major
risk is the correlation between the alpha and the index that
the beta portfolio is replicating.
Prince: I think that an alpha overlay, or portable alpha strate-
gy, inherently has huge advantages in terms of risk control
simply because you have the ability to diversify so much
more. You can bring so many different types of alpha that are
uncorrelated into the portfolio that your exposure to any one
of those types of alpha is substantially reduced. That's the
big headline. The sub-headline is that if you don't do it right,
you can mess it up. For example, some people are drawn to
certain apparent alphas that have a certain amount of
observed risk that's then leveraged up, but there’s a lot more
actual risk than is apparent in the historical returns. Any kind
of strategy that's essentially a selling of options, like earning a
credit spread, mortgage spread or any kind of a short options
position has an appeal because it produces a dime of profits
every quarter with a relative degree of consistency, but offers
a dollar of risk that is not observable in the data.
Clark: One risk in a portable alpha strategy is not acknowl-
edging that there could be structural beta or some short-term
conditional beta included in the alpha portfolio. So you can
find yourself with more or less beta in your overall portable
alpha strategy than was originally anticipated.
Moderator: What resources are required for a client to run a
portable alpha program with hedge funds as the alpha
source?
Ohmura: It really depends on the type of solutions clients are
looking for. With a bundled solution, clients are not required
to have any extra resources. It's just like buying a fund. For
investors who are going for the unbundled solution, where
alpha and beta are run independently of each other, they
would need the operational and risk management resources
required to deal with over-the-counter derivatives or a futures
Yoshiki Ohmura, GAM: “There is usually a lot more risk in
the beta component than in the alpha piece.”
6 • Alpha Sponsored Roundtable • November/December 2006
Kent Clark, GSAM: “If you can find real alpha, then it’s a
matter of engineering beta into it.”
contracts as well as substantial legal capacities for negotiat-
ing and executing various agreements that are required. That
can be quite substantial, especially for an institutional client
who is not active in the derivatives market yet.
Clark: The reason we're talking about portable alpha is that
there may be institutional or intellectual constraints around
the whole idea of going all the way to pure alpha strategies,
away from beta. One of the conveniences of having the
portable alpha and beta done by someone else in a package is
that then you can use many of the same evaluation tools with
your portable alpha provider that you used before in tradition-
al asset classes and traditional active management. The hard-
est part is finding the alpha. If you can find real alpha, then it’s
a matter of engineering beta into it – being very careful about
counterparty risk, and being very careful that you evaluate if
there is beta embedded in your alpha source or not.
Moderator: What should investors look for in a portable alpha
provider?
Gieger: Investors should look for a solution that's going to fit
their needs. Whether it's about generating a return in excess
of a particular benchmark or mitigating other risks within the
portfolio, that's what they should be targeting. They should
also look for a provider that they can understand. They
shouldn't go blindly into strategies that are not fully transpar-
ent, not easy to use, and do not offer a complimentary risk
return profile to their benchmark or beta of choice.
Clark: If there's no alpha, then you don't want to take it any-
where. So first, find the alpha and then find the resources in-
house or with that alpha provider to efficiently and effectively
execute your beta part.
Prince: You have to find a provider who can beat the
markets. You want a positive expected return that is uncorre-
lated to your other alphas and betas. You want a great risk
control process within that alpha, particularly with respect to
event risk. You want back-office operations that are well run.
And then, you want to see the ability to engineer, expand and
shrink the risk, combine it with different things, and cus-
tomize as necessary. ■