Carried away with alpha
Although enhanced indexing is a strategy for generating limited levels of outperformance, portable alpha is another technique for adding value, and one which has the huge potential advantage in that it can be used to boost returns in an unconnected part of the portfolio.
Portable alpha is generated using derivatives in connection with underlying securities. James Scott, president of Quantitative Management Associates (QMA), which is part of Prudential Investment Management in the US, says: “You have an underlying securities portfolio, and then you use most commonly futures to move that alpha to another asset class.”
How does it work? For example, if you have a $10m (e7.5m) investment in an S&P enhanced indexing fund – you would short $10m of equity futures. The result after a period of time, is that your market exposure nets down to nothing, and all you are left with is the alpha, says Scott. Then this alpha can be used elsewhere in the portfolio.
“So if you want to port it to your bond portfolio, you go long on the future in that asset class, so you end up with the bond return,” but the alpha from the equities, he says. “You’re taking all the bond risk, because you’re long in bonds.”
At the moment there is a lot of talk about portable alpha and what its possibilities are. But there is more talk than action, says Scott, who suspects investors are afraid of the concept because it is a new one. “In theory they get it, but they don’t implement it,” he says.
But there is also the problem that the method may lead to heavy reliance on a single or small number of managers. In the formula, the real active management risk does lie within equities. “So if it’s the same manager, you’ve got a lot riding on that one manager,” he says. But even if you choose to use different managers, as long as they are all within the sphere of equities, the alpha of all these managers will be correlated.
“It’s a good reason to be_wary,” he says. “You want to think carefully about how you place your bets in a large institutional portfolio.”
Where portable alpha is used, in practice it usually takes the other direction. “Most of the action is probably going the other way, from the bond market into the equities market.” Where there is significant use of portable alpha is in cash strategies and short-term bond strategies with managers such as PIMCO and Western Asset Management, says Scott.
In such cases, managers take the short T-bond fund, use futures to short that, and then go long in the S&P 500 futures, and so provide enhanced equities. “There are a lot of products like that,” he says.
“Generically, they tend to have lower tracking error than typical enhanced equities managers - less than 1% - so they are low risk, but low return.”