Fund of funds, portable alpha, and portfolio optimization

The authors examine the portfolio optimization problem that arises when a manager's mandate is a fund of funds with an asset allocation benchmark. The portfolio manager's objective is to maximize the portfolio excess return over the benchmark subject to given tracking errors. The authors decompose total tracking error into two compo-nents-the deviation from the benchmark and the addi-tional risk factors associated with fund alpha. By quantifying the contribution of each component of port-folio excess return, the authors show that the performance of the style-constrained portfolio is determined by the active alpha-seeking skill of the portfolio manager and that fund alphas can be separated from their style loadings and are portable. These findings will not only help investors determine optimal tracking error constraints, but will also provide a framework for portfolio managers to identify funds with certain characteristics in order to achieve an optimal portfolio return.