Portable Alpha

Changing Expectations

Alexander Shaw, Head of UK Institutional and Northern Europe at GAM
Originally published in the September 2006 issue

‘Portable alpha’ has been called everything from a ‘new paradigm’ to a ‘fad’ in recent press articles and most industry participants have developed a strong view one way or the other. Along this spectrum, GAM’s view is much closer to the ‘new paradigm’ end, although there are a number of variables that need to play out before a winning side is declared.

Portable alpha has been used by insurance companies, corporates and investment managers for around 20 years. It was developed on the back of the asset management industry’s adoption of Robert Merton’s Capital Asset Pricing Model (CAPM), first introduced in 1973.

As the CAPM embedded itself as a central tenet of investment thinking in the 1970s and 1980s, and the derivatives markets began their upward spiral, investors developed techniques to utilise its two main components separately and more effectively – beta being market exposure and alpha being manager skill or outperformance – and capture them from different sources. These techniques became known generically as ‘portable alpha’, when in fact, investors can ‘port’ either alpha or beta.

Divide and conquer

Portable alpha is a logical concept although its implementation can be complex. For instance, an investor may want exposure to a specific market, such as the US equities market, in which it is difficult to find managers who outperform consistently. So, he would buy derivatives on, for example, the S&P 500 index, to generate the return of that market and pay LIBOR (cash) plus a spread for the privilege.

Since derivatives cost only a fraction of their value, the investor would be able to invest the majority of his capital in a strategy and manager whom he expects to outperform LIBOR consistently, such as an experienced manager of fund of hedge funds. If all goes to plan, the return of the S&P 500 less LIBOR, plus the net performance of the fund of hedge funds, should give the investor a consistently higher return from his investment than investing directly in equities. In addition, he has achieved this without changing the overall asset allocation of his portfolio.

Portable beta, though less common, can work similarly, effectively letting an investor keep exposure to a high performing manager, but swapping away an underperforming market. For instance, if an investor has a good manager of global equities but he is convinced that the equities market will produce negative returns in the medium term, he can short his exposure to that market using derivatives and invest the capital in an index fund on a rising market, by buying passive exposure to the Lehman Aggregate Bond Index, for instance. He therefore effectively ports the beta from a rising asset class whilst retaining the alpha from his outperforming manager; however, he has changed his underlying asset allocation. This sort of scenario serves to demonstrate the flexibility that separating alpha and beta offers investors.

US endowment funds led the way in using portable alpha strategies, particularly in recent years, and, as is often the way with institutional trends, US pension funds have been quick to follow over the past three years or so. A report published by Morgan Stanley in 2005 argues that portable alpha represents a paradigm shift in investment management. It reported that 33% of large companies in the US were using portable alpha programmes and a further 23% were considering them. The study also concluded that 15% of US public pension plans are already using portable alpha, and 37% were considering using it.

Other market sources estimate that assets invested in portable alpha strategies will reach USD1 trillion in the next few years and that growth in structured products, including portable alpha, derivatives and exchange-traded funds, is expected to overtake growth in hedge funds in the institutional marketplace in the same timeframe. These are high expectations indeed.

Drivers, dynamics and obstacles

Despite the growing numbers of investors and the optimistic forecasts, significant challenges remain both for investors and for the fund managers designing and managing these strategies.

The challenges that institutional investors now face are fairly common across mature pension markets from Kansas to Korea and Australia to Austria. The interest in more sophisticated investment approaches is driven primarily by the need to achieve relevant investment targets. Spurred on by continuing legislative and corporate pressures to bring their defined benefit pension plans to fully funded levels, pension funds have been exploring the world of alternative investments for a number of years so portable alpha is the next logical step for the increasingly sophisticated range of choices for pension fund trustees. These changing market dynamics have also led to increased interest in the idea of absolute return investing, focused either on capital preservation or on outperformance of liabilities, rather than the more traditional view of looking to outperform an index or peer group benchmark.

Many larger plan sponsors have just become accustomed to the idea of using hedge funds, commodities and private equity, however, the number of options available in alternatives will continue to challenge trustees, as they keep evolving. Moving a step forward to being comfortable with the notion of using derivatives, therefore, is made more difficult for many trustees. The sheer volume of information via conferences, thought-pieces, advice, specialist consultancy services, investment banking white papers and educational materials on derivatives, in general, and portable alpha, in particular, goes some way to filling the knowledge gap. However, these strategies are not for everyone.

The evolution of access

Once trustees have bought into the idea of portable alpha as a viable option for their plan, their next challenge is to identify the right provider. Portable alpha means borrowing money to invest, so investors need to have a high degree of confidence in their alpha generator, not to mention in the ability of their beta portfolio manager to replicate the underlying index.

These are two very different skill sets. Because of this, unbundled portable alpha solutions have historically enjoyed widespread popularity.

However, this approach has problems, requiring investors to conduct separate due diligence exercises on the providers, perform ongoing monitoring and endure set-up of bespoke vehicles and the opportunity costs and hard costs associated with these strategies. Perhaps the most onerous part of using an unbundled strategy is that the investor must post assets and collateral and carry liabilities directly, as well as setting up ISDA, credit support and collateral agreements. This can also have a knock-on effect of complex accounting treatment for corporate reporting.

These hurdles have encouraged the increasing popularity of bundled solutions. Under such arrangements managers pull together specialist teams from in-house or third parties to create a seamless, pooled offering that carry lower cost and effort on the part of the trustee. That said, they still require close due diligence to ensure that the provider has the necessary expertise to manage both the alpha and beta portfolios. To be competitive in the market portable alpha managers need to innovate and differentiate themselves through the flexibility of design, accessibility of vehicles, transparency of reporting, active management of the beta portfolio, reduction of counterparty risk and techniques to enhance the amount of capital that can be invested in the alpha generator. These new generation portable alpha engines are setting the bar ever higher for new entrants and are pushing innovation in a way that benefits investors.

Generating alpha

The most important component of a successful portable alpha strategy is the consistent generation of alpha above cash across market cycles. Generally successful alpha generators need to have several features:

  • Proven and stable returns over market cycles
  • Consistent outperformance of cash
  • Low correlation to benchmark
  • Low beta when measured against benchmark
  • Low volatility and ‘tail-risk’

Though hard to say definitively given the high number of strategies run in-house by corporates and insurance companies, the most common alpha generators historically appear to have been equity market neutral or fixed income based strategies. Today alpha generators include virtually every type of asset class and strategy available on the market: global tactical asset allocation (GTAA), currency, commodities, property, private equity, single strategy hedge funds and multi-strategy funds of hedge funds. Given the list of desirable characteristics, it is not surprising that many of the prime candidates for alpha generators are classed as ‘alternatives’.

GAM believes that funds of hedge funds tick most, if not all, of the boxes. By design, funds of hedge funds aim to produce consistent, higher risk-adjusted returns with low correlation to traditional markets. The primary objective for most of the underlying strategies is to generate strong absolute returns while protecting capital, which is in line with the overall objective of the vehicle. This absolute return focus means hedge funds often measure their performance versus LIBOR, which is the primary outperformance target of the alpha engines.

Funds of hedge funds also tend to exhibit lower volatility than traditional equity markets, providing a better risk/return trade-off than many other asset classes. Including these in a portable alpha framework improves the overall risk/return trade-off of the strategy. Many types of fund of hedge fund strategies also provide low correlation to traditional markets over the longer term, meaning they will achieve the independence they need to generate alpha successfully. Finally, they exhibit a medium to high correlation to cash, which enables them to provide consistent returns across market cycles.

Delivering beta

As for the other side of the portable alpha strategy, not all beta engines are created equal. Investors should look for specialist teams who are experienced in managing a wide range of derivatives across market cycles. The manager must have in-depth structuring expertise to ensure they are able to optimise the beta portfolio to achieve investment objectives efficiently. This expertise should manifest itself in minimal tracking error, best prices for derivatives and reliable counterparties.

The choice of investment market to be tracked is also important. “The prime markets for beta tracking are ones that are information-rich and efficient, with liquid derivatives markets and many market participants. This helps them to be cheap to replicate and means they have low margin requirements,” comments Yoshiki Ohmura, Head of Alternative Risk Trading at Baer Alternative Solutions. Mr Ohmura is responsible for derivatives and structuring and manages the beta portfolios for GAM’s portable alpha strategies. He continues, “Typical indices for beta portfolios of portable alpha strategies are the S&P 500, DJ Euro Stoxx 50, MSCI World, FTSE All-Share, Russell 10002000, Nikkei 225 and Lehman Brothers Aggregate Bond indices. The list is expanding all the time, underlining the flexibility that structured products provide institutional investors today.”

Aims and achievements

Portable alpha strategies are designed to provide investors with a more efficient route to achieving outperformance of an index, to decrease risk as a result of the independent source of that outperformance and to enable tailoring of the exposure, risk and return desired by the investor.

But does portable alpha actually deliver? GAM’s own modelling techniques have shown that adding portable alpha to a typical portfolio of equities and bonds does indeed provide a higher level of absolute returns, as well as a better risk/return trade-off, just as the theory said it would.

Our analysis below shows an efficient frontier for a portfolio. The effect of adding a portable alpha strategy using the S&P 500 index as a beta portfolio and a diversified, multi-strategy fund of hedge funds (here, GAM Diversity) to a traditional 60% US equity and 40% US bond portfolio is a better risk/return trade-off:

Research published in 2005 by Strategic Insight Global , a US investment research firm, estimates that historically, portable alpha techniques have added 20% to information ratios because they effectively “widen the opportunity set” through which investment strategies gain returns.

Furthermore they report that the separation of alpha and beta is expected to result in at least a 100% increase in net alpha for a typical defined benefit plan.

Portable alpha is an intuitively appealing concept based on sound investment principles. The long-term growth and accelerating take-up of portable alpha strategies seems to be testament supporting this research and some of the more optimistic projections. GAM believes that as an approach, portable alpha is here to stay and will embed itself as a core strategy for institutions in the long term.