The portable alpha trend
More and moreUS pension funds are adopting or thinking of using portable alpha strategies. About 13% of the 176 North American participants in the last Russell Survey on Alternative Investing - large pension funds, endowments and foundations - currently utilise portable alpha strategies, 24.6% don't use them but are considering doing so and only 22.3% do not use them nor are considering using them. "We have seen acceleration during the last two years," says Michael Thomas, director of overlay services with the Russell Investment Group, a 20 people team who run derivatives.
Russell manages over $20bn
(€15.5bn) in derivative overlays, half with portable alpha strategies. According to Thomas the first reason for the growth in portable alpha strategies is the availability of the instruments, the derivatives necessary to separate alpha from beta, which opens the doors for more efficient portfolios. "What many investors have found is that the areas with higher alpha potential got the least allocation because of the limits to preserve a prudent trade-off between risk and return. Portable alpha strategies break the link between the alpha generated in an asset class and its underlying exposure, allowing more exposure to the attractive sources of alpha without the unwanted byproduct of their accompanying market exposure".
The second driving force according to Thomas is "the pension funds' need to find every possible basis point and portable alpha strategies are one of the sources of extra returns", but he adds that "right now investors are pursuing these strategies in a very narrow way" so Russell advice is "if an investor is going to port alpha somewhere, it makes sense to port it to the underweighted class so it gets a free rebalance of its portfolio".
Some critics claim it's only a new product craze, with new underestimated risks. "It's true there is some re-packaging and product pushing going on, but there are also very real reasons to consider portable alpha strategies," observes Benjamin Poor, senior analyst with Cerulli Associates.
Pension funds are adopting them because they are frustrated by the 2000-2002 bear market that shocked their confidence in active equity managers, who on the other hand have been given a tough task during the last 20 years: producing alpha without much deviation from benchmarks. Pension funds have also realised that indexing is not really a solution.
"Pension funds are savvier in using their risk budget while the use of derivatives is becoming more mainstream", claims Jane Tisdale, senior managing director at State Street Global Advisors, which in the past year has doubled to $1bn its assets in portable alpha strategies and is optimistic about the growth of this business.
"We've seen portable alpha mandates by all kind of pension funds," says Tisdale. Another driver of the new trend, according to Bill Dewalt, Watson Wyatt senior consultant, is that US pension funds are moving to mark to market accounting and to liability-driven investments, the system already in place in the UK and Netherlands.
"The American Financial Accounting Standards Board is working on changing the rules towards the mark to market way, and the Congress is working on pension reform legislation that would eliminate the smoothing of asset values," says Dewalt , "People know it is coming".
Both Poor and Dewalt express concern about pension funds' understanding of the risks involved with portable alpha strategies. "For example, do they understand the real source of the alpha?", asks Poor. "Many investors have an oversimplified idea of alpha, they think it's any type of performance not directly linked to the S&P 500. Or they think it is the carry trade, borrowing money at minimal interest rates and investing it by exploiting the discrepancies between short and long bonds: but that was a strategy hedge fund managers could do in 2003, taking advantage of an opportunity that doesn't exist anymore and that was not really alpha." Poor says another question for pension funds is "where the real money is going to be invested?"
"When you choose a long/short hedge fund for the active component of a portable alpha strategy, you have the potential for high risk or major underperformance, possibly more risk than just shelving the portable alpha concept and choosing a high-quality traditional asset manager."
"Adopting portable alpha strategies requires higher governance skills," according to Dewalt. Trustees or fiduciaries need to understand more what they implement and need ongoing monitoring, because these strategies involve new risks -not necessarily more, but different ones - that today pension funds don't face. Besides, there isn't much transparency with some strategies: it's not obvious where they invest, and pension funds may not understand they need to manage cash flows associated with derivatives."