Alchemy to the rescue?
Portable alpha offers pension funds the investment equivalent of alchemy – transmuting non-performing into performing assets. Using swaps or futures contracts - a process known as equitisation - funds can transfer or ‘port’ the alpha generated by one asset class to other asset classes in their portfolio.
In this way, pension funds can increase their investment returns without changing their existing asset allocation.
Investment managers are enthusiastic about the potential of the new alchemy. Credit Suisse Asset Management, in its recent paper ‘A Portable Alpha Primer’ suggests that portable alpha has arrived at precisely the right moment for institutional investors.
“On the one hand investors are moving to reduce costs by shifting to more efficient passive management. On the other hand many are seeking greater exposure to alpha generating absolute return vehicles that, regardless of general market performance, offer the potential for higher and more stable excess returns than traditional benchmark constrained funds.
“Portable alpha can potentially help achieve both goals simultaneously.”
The CSAM report says the building blocks for portable alpha - liquid derivative markets, index benchmarks and increasing numbers of alpha strategies - were already in existence before the current interest in portable alpha.
It sees the arrival of portable alpha as evolutionary rather than revolutionary; a development of current asset management practices rather than a step change in asset management theory.
“The missing link in this evolution, the spark that would set the portable paradigm in motion, was the impact of the market downturn and the pressure plan sponsors have faced in meeting their target return assumptions.
“In our view, the current trend in portable alpha was born amid the effort to wring as much efficiency out of the portfolio as possible and to overcome the inherent constraints of traditional investment management.”
The benefits of using portable alpha are considerable, say its proponents. In their paper ‘Portable alpha – philosophy, process and performance’ Edward Kung, senior manager product development, and Larry Pohlman, director of research at Panagora Asset Management argue that using portable alpha enables institutional investors to budget risk, maintain strategic asset allocation, avoid making wholesale changes to their existing manager structure, and clearly measure portable alpha performance.
Yet there is a downside. Kung and Pohlman remind investors that derivative transactions are not free. “Transaction costs will surely reduce alpha,” they warn.
The also point out that index futures may not always track the benchmark perfectly, and that investment managers will need to manage the futures position actively.
Furthermore, some asset classes may not have the necessary liquid futures contracts. Investors who want to port the alpha from these assets will be forced to use more expensive instruments such as swap contracts or exchange-traded funds.
The sources of pure alpha are also uncertain. To modify 18th Century cookery book writer Hannah Glasse’s advice on making a ragout, “to create portable alpha, first catch your alpha”. Portable alpha is not possible if there is no alpha to port.
Robin Creswell, managing principal of Payden & Rygel Global suggests that what is often transferred is beta rather than alpha. “The growing discussion about alpha should be questioned. The bets some people are placing on generating alpha may not be those intended.”
“Alpha in most of its forms is quite simply the additional return some investor receives at the expense of another. Much of what is being offered is simply the transfer of the higher intrinsic return associated with one class, say emerging market bonds, to a lower intrinsic asset class, say global bonds. These would be better described as beta transfer strategies, not alpha transfer,” says Creswell.
Institutional investors have tended to look to hedge funds or funds of hedge funds for sources of alpha, Kung and Pohlman suggest. The main sources have been market neutral and long-short strategies because of their low correlations with market indices.
Yet not every alpha-generating hedge fund is appropriate for porting alpha, they warn, suggesting that hedge fund managers are “not that unique in identifying alpha opportunities”.
In some cases hedge funds may not be generating alpha at all. Research by Greg Jensen and Jason Rotenberg of Bridgewater Associates has shown that some hedge fund managers are merely repackaging beta and selling it as a pure alpha strategy.
Jensen and Rotenberg found that fixed income arbitrage, emerging market, managed futures and merger arbitrage indices were strongly correlated to straightforward strategies of mortgages, short term corporate, and emerging market equity.
The alternative to hedge funds for sources of alpha is traditional long-only managers who run portable alpha strategies as a variation of an existing long-only fund. Peter Chiappinelli, director of institutional investment strategy and research at Putnam Investments, says it is possible to find alpha in long-only managed asset classes. All that is needed is a change of approach.
“Traditional approaches look for alpha, or excess return, in the same group of stocks that make up their beta, or benchmark. The portable alpha approach breaks the traditional linkage between the benchmark and the excess return.”
“This allows investors to get their benchmark return from one source, and their excess return from a different one. More importantly, it enables them to look for excess returns in places where active managers have historically had a better chance of creating it.
One area is US small caps. These have historically been rich sources of alpha for active managers “Why? Because it’s an inefficient market and you’ve got to go fishing in it,” says Chiappinelli.
In the five years ending 2003 the returns for the median small-cap manager taken from a large universe of active managers (Manager A) was 11.9% annualised. This return had two components: the return for the benchmark or beta, The Russell 2000, which returned 7.13% annualised; and the excess return, or alpha, which was 4.86% (Chart 1)
“All we really want from Manager A is their excess return, only one of the two components. So we need a way of removing the benchmark component that we don’t want while keeping the excess return component that we do want,” Chiappinelli explains.
Derivatives are used to make the alpha portable, he says. “By shorting Russell 2000 futures, we are in essence removing the unwanted Russell 2000 component of the US small-cap manager’s total return,” says Chiappinelli. “All that’s left is the excess return.” (Chart 2)
Having isolated the alpha, the next step is to attach it to the required benchmark, in this case the S&P 500. So the proceeds from the sale of Russell 2000 futures are used to buy S&P 500 futures.
One of the major problems with this approach, Chiappinelli says, is that Manager A’s alpha, while good on a five-year basis, looks much more erratic in shorter time frames.
The solution, he says, is to combine the portfolio of Manager A with that of a different manager in a different asset class. (Manager B), for example, non-US stocks represented by the MSCI EAFE Index. In this case, the excess returns of both Manager A and Manager B are stripped out and combined (chart 3).
“The combined portfolio has a very compelling profile. It’s always positive, not nearly as lumpy as the individual strategies, and completely portable. What makes this possible is that the managers’ alpha streams have a low, even negative correlation to each other. The classic benefits of diversification are kicking in, but this time in alpha-space.”
Chiappinelli says that there is no reason to stop at two managers “Our analysis shows that combining eight to nine alpha sources into a diversified alpha-portfolio can create a more consistent alpha stream that can be ported onto a desired benchmark.”
While inefficient markets like US small caps provide the alpha for portable alpha, derivatives provide the portability. Derivatives also have cost advantages. Investors can buy index futures contracts for 5% to 10% down, allowing the remaining investment to be put to work in alternative, alpha seeking investments.
Yet one of the obstacles to pension funds’ acceptance of portable alpha strategies is the use of derivatives that these strategies involve. There is still some reluctance among pension fund boards and trustees to sanction the use of derivatives, says Paul Bourdon, director investment solutions at Threadneedle Asset Management.
“In terms of using derivatives some funds still have difficulties. Either they are not allowed to use derivatives directly or they don’t want to handle them directly. That’s why fund managers like us have developed wrappers that allow them to get the economic function of the derivative without having to deal directly in it. It is a sort of swap overlay inside a wrapper, which has the impact of delivering the portable alpha.”
One feature of portable alpha, designed to reassure pension fund boards, is that its use will not necessarily involve a major change in asset allocation, he says.
“If pension funds have got some equities run passively against the FTSE index where they could bring in some alpha to stick on to it, they wouldn’t necessarily have to change what they’re doing. Instead of having the money managed passively they would use those fund in the alpha funds.
“So if they want to remain 40% in equities they can still remain 40% in equities against say the FTSE benchmark they’ve got, but some or all of those funds would be invested in something very different, which is generating the alpha.”
The growing interest in liability-driven investment (LDI) strategies is creating an investment environment that is more favourable to the introduction portable alpha strategies, Bourdon suggests.
“The traditional approach to managing assets tends not to incorporate the introduction of portable alpha. The LDI approach to managing assets, which is looking at the liabilities as the benchmark and then looking at the assets to deliver the benchmark, is where people do start to introduce portable alpha to give extra return, over and above some of the benchmark type returns, which are needed to deliver long-term performance.”
Yet take-up of the idea has been slow, he says. “Fund managers are only just getting to grips with the packaging, which may have been a reason why these things haven’t been done widely yet. It’s only very recently that pension schemes have looked at portable alpha in terms of bringing in some extra returns on to their portfolios in an LDI context.”
Portable alpha is perhaps more palatable to institutional investors such as pension funds if it is promoted under another name. Kevin Carter, head of European investment consulting at Watson Wyatt Worldwide suggests that pension fund boards and trustees are more familiar with concepts like global tactical asset allocation (GTAA), portable beta and alpha in all but name, and therefore more willing to incorporate it in their investment strategies.
“There is a readiness to think about global tactical asset allocation managers as overlay managers within the existing structure. Although trustees may not know it, GTAA is a form of porting beta (market returns) which, if done well, can create some alpha because the asset manager is taking positions for and against asset classes against other assets classes. That is de facto porting around different betas and hopefully getting some alpha on the way,” Carter argues.
“My sense is that there has been relatively little money committed to portable alpha and beta other than in the GTAA space. If pension funds put any money into this area they think they are allocating to a GTAA manager rather than choosing a portable alpha strategy. But eventually those two dots will be connected.”
Carter suggests that there is also a growing acceptance of some of the building blocks of portable alpha, such as derivatives. “After funds moved from equities into bonds, there was a recognition that the total return of the fund has gone down so they need to make bond assets work harder. That means either giving existing fund managers more liberal investment parameters or employing some new ones with more aggressive mandates. Those typically would include the use of derivatives.”