Applying an objective view
One of the reasons that portable alpha has yet to be adopted by pension funds may be that it does not appear to meet their needs. Although it is conceptually attractive, its seems to have no practical application.
Ronald Ryan, founder and CEO of US-based Ryan Asset Liability Management believes this is because the finance industry is using the wrong benchmarks.
“If portable alpha is done correctly it is the most prudent and effective way to manage assets versus any liability-driven objective,” he says. “The problem is that the finance industry clings to asset-driven strategies and ends up with the wrong risk/reward behaviour due to the wrong objective.
“The objective of a pension fund is to fund the liabilities at the lowest cost to the plan taking prudent risks. It follows that if you outperform any generic index but lose to liabilities, you lose.”
Ryan argues that generic indexes have no relationship to the unique liability structure of a pension plan. “Pension liabilities are like snow flakes. No two are alike.”
The starting point for a more relevant use of portable alpha is what he calls a custom liability index – an index that can price and calculate the present value term structure and growth rate of a pension fund’s
A custom liability index enables the construction of a beta portfolio, he says. “By definition the beta portfolio for pensions is a liability index fund. Many practitioners use beta in portable alpha strategies as a generic index fund. This is not beta.”
For Ryan, beta is the core portfolio that matches the pension fund’s liabilities, and will typically contain zero coupon government bonds.
The alpha portfolio will contain non-fixed income assets, with the exception of high yield corporate bonds, which have equity-like characteristics.
Once a custom liability index is installed, portable alpha can come into play, he says. The index will determine the funded ratio of the pension and the measurement of the deficit or surplus. It will also determine the growth rate that the alpha portfolio must beat to earn alpha.
The allocation to beta will be based upon the pension fund’s funded ratio. The bigger the deficit the greater the allocation to the alpha portfolio and vice versa.
As the alpha portfolio performs by outgrowing liabilities, the excess return is ported across to the beta portfolio regularly. The beta portfolio will reinvest these to match the
As the alpha portfolio’s excess returns are ported, the beta portfolio grows, reducing the contributions costs of the pensions fund and the interest rate risk as the beta portfolio will now match and track the liability profile.
In this way, Ryan suggests, portable alpha achieves what the asset allocation was designed to do.
“Asset allocation’s intention was to create a synergy among asset classes that meets and beats the client objective with prudent risk. This is still ideal. What was missing was the client objective as a custom index and the discipline to shift funds to a less risky allocation when you’re winning. Portable alpha can now solve this deficiency if it is based on liabilities.
Ryan re-defines portable alpha as “the synergy of transferring funds from the alpha portfolio to a liability-matching beta portfolio, based on the excess returns of the alpha portfolio versus a custom liability Index.”