Institutional investment portfolios have typically been constructed around a strategic policy portfolio and where investors believed that they could identify managers with skill, they adopted an active strategy to add value relative to that benchmark. Where active management is adopted there are two sources of return – the return attributable to the market and, ideally, a return in excess of the market due to a manager’s stock picking ability. In this paper we discuss techniques that allow a fund’s asset allocation decision and a component portfolio’s outperformance (alpha) to be separated. This process is known as ‘alpha transport’ or portable alpha.
The concept of ‘alpha transport’ has been around for a number of years but too often there has been little explanation of what it means or how it can be used practically in portfolios at the asset class level. In practice, ‘alpha transport’ has been around in many guises and has been practised within portfolios by managers for sometime, but until recently the use of ‘alpha transport’ in asset allocation it has not been widely utilised. For example, within fixed income portfolios, overseas bonds are widely held due to the increased opportunity set with the currency risk hedged back to the investor’s base currency.
Two trends have brought the discussion on portable alpha techniques to the fore. First is the risk reduction exercise that many funds are executing with increasing allocations to bonds and commensurate reduction in outperformance opportunities. Secondly, a realisation that certain markets are easier for an active manager to outperform in than others. We discuss further why this is the case below.
The net result from an asset allocation perspective is that the fund manager is not restricted to generating outperformance solely from those markets in the strategic policy portfolio.
‘Alpha transport’ is simply the separation of ‘active’ risk from the underlying market risk – typically expressed as a benchmark. Without opening the debate on the definition of ‘active’ skill, for the purposes of this discussion we will define ‘active’ skill as the repeatable activity that generates a return in excess of that generated through a passive benchmark. In order to use ‘alpha transport’, in addition to assuming you have identified alpha, you then have to transport it. The mechanics of this are detailed below but the key criterion is that the underlying market exposure can be removed and replaced with a desired market exposure. The cost of this hedging is critical in looking at the overall success of the effort. This will be laid out more clearly later on. Lastly, we will discuss a particular trait of alpha – namely the low correlation to other alphas and how this can be exploited in portfolio construction.
It is commonly known that in some markets it is tougher to beat the index than in other markets. This is often referred to as ‘market efficiency’. Unsurprisingly, the markets with the largest savings pools and the largest number of market participants are the ‘most efficient’. Figure 1 shows our analysis of the Lipper and Micropal universe of funds and where the index return and +1%, +2%, +4% outperformance ranked over rolling three-year periods1. This clearly shows that finding a fund manager that can outperform US or UK government bonds by 1% is very rare indeed. A US equity manager achieving 1% above index returns would be in the 77th percentile of all active managers. This is made even worse as the excess returns of managers are ‘less durable’ the more efficient the market. In US equities, 358 managers were top quartile in 2000. By 2004 the number of same managers that continued to be top quartile had dropped to 172.
Only 4.7% of top quartile US equity managers, or 0.75% of all managers, were able to maintain their top quartile status in the five years from 2000 through 2004. Unfortunately the situation is even worse for US government bond investors, where the number drops to zero after only four years!
Exploiting the inefficiencies
In other less efficient markets, investors are given a greater chance to outperform. As demonstrated in figure 1, the index finished in the 55th percentile of all European equity funds and in the 39th percentile of all Japanese equity funds in the universe. In addition, these outperforming managers exhibited a greater degree of durability in their performance. Top quartile Japanese managers fared better than their US counterparts having roughly 13% stay in the top quartile over the five-year period.
In Europe, the results were in between the US and Japan, roughly 8% of top quartile managers managed to maintain their position over the five-year period. While these numbers are seemingly low, they substantially improve the odds over time for an investor.
So how do investors get reliable alpha from their allocation to efficient market investments? Often the choice has been to hold these markets passively and rely on alpha generated elsewhere in the portfolio – effectively letting other investments provide the managers to produce the alpha shortfall. Unfortunately, this creates problems of its own, namely making the total alpha dependent on the amount of the passive allocation and encouraging risk taking in other parts of the portfolio. This may or may not be appropriate to make up for the alpha shortfall. For example, significant passive allocation (say 30% of the overall portfolio) would require managers to take over 35% more risk assuming the same information ratio to achieve that same level of overall alpha. This becomes more problematic as information ratios typically deteriorate as risk levels rise.
‘Alpha transport’ provides a solution. By transporting the alpha from an active manager to a passive allocation, investors can in effect, leverage skills in less efficient markets and apply them to more assets in the portfolio. This can be done simply by changing the market exposure (by using derivatives) to the one that is ultimately desired by the investor.
Alpha as a diversifier
In addition to being portable, alpha has some properties that makes it very desirable in portfolio construction beyond the obvious advantages associated with higher returns. Unlike market exposures (beta) where correlations are unstable through time and often range from significantly positive to significantly negative, the correlations associated with alpha are typically random over time and low as illustrated in figure 3. This means that from a diversification perspective they are superior to trying to manage overall portfolio volatility using only beta exposures. We can therefore treat alpha as its own asset class (with corresponding volatility and correlation characteristics) and identify the optimal amount. This aspect of alpha can become very powerful when considering portfolio construction and provides a strong argument for an element of active management even with low alpha assumptions.
In summary, it is widely acknowledged that some markets are more efficient than others, however few investors take advantage of that fact in their portfolio construction. By implementing simple ‘alpha transport’ techniques at the portfolio level (or letting their manager do so), investors can improve their overall return and risk relationship and lower their transaction costs. In addition, by taking this one step further and modelling alpha as an asset class, investors can optimally combine their active and market risks and improve their portfolio’s risk and return. For pension fund portfolios, ‘alpha transport’ has three primary advantages:
n Allows a reduction in portfolio
risk relative to liabilities while maintaining return seeking
n Provides an additional layer of portfolio diversification;
n Allows investors to seek return where it is most rewarded without the associated market risk.
1 Source: Micropal, Lipper, Schroders; Percentile ranking of widely used indices on a rolling three-year basis up to 30 June 2005. 100 best 1 worst. Mutual fund returns are measured after all fees.
2 Source: Lipper, Schroders