Generating alpha in a lower return environment has become investors’ most important goal. Over the recent past the trend towards separating alpha and beta investments has resulted in the development of sophisticated portable alpha strategies that present themselves as efficient solutions to solve funding problems.
In brief, portable alpha strategies involve separating alpha from beta by investing in securities that differ from the market from which beta is derived.
To do this investors have to first identify a way to generate alpha or, in other words, to add value against a particular benchmark. Once this is done, the created alpha is added onto the portfolio by using swaps or future contracts in a way that the strategic allocation remains largely unchanged.
Portable alpha
The concept of portable alpha is not new and, in fact, investors have been using these types of strategies for over two decades. The difference now, however, is that portable alpha strategies are gaining widespread acceptance among institutional investors globally. One of the reasons for this is that pressure on investors to improve funding levels is greater than ever. But also institutions are now more familiar with the wide range of alternative or sometimes more exotic investment strategies used when implementing portable alpha.
“We are now finding a great deal of acceptability for strategies that look to generate alpha and also to move that alpha around,” says Robert Brown, partner, senior investment consultant at Watson Wyatt, during a recent conference in Barcelona.
“One of the reasons why portable alpha has become more important is the gradual shift of institutional investors from relative return concepts — portfolios related to some kind of equity or bond benchmark — to those which are perhaps more relevant to their liabilities.” Mr Brown explained that there has been more demand for strategies that generate cash plus or Libor plus returns, particularly among institutions that have large swap programmes and are trying to reduce the risk in their liabilities.
Historically most institutions looked at taking risk in the asset allocation space. “At the end of the 1990s it was very much about reliance on the equity risk premium. The shift towards liability matching has meant quite a significant increase in the desire to buy alpha, whether alpha is around.”
Periods of underperformance in the long-only markets at the beginning of the decade have resulted in investors focusing more on risk-adjusted returns. Moreover, those investors that until now were mainly taking risk on the asset allocation part of their investment strategies, are now thinking of taking risks on the alpha section too.
“I think what we will see going forward is quite a change in the balance of those
risks and how those risks are managed,” Mr Brown said.
CSAM paper
At the end of last year Credit Suisse Asset Management (CSAM) released a paper on portable alpha explaining how these strategies enable investors to seek alpha generation from a specific asset class or investment strategy that may not be part of the strategic beta allocation.
In its paper, CSAM gives us as an example the case of an investor with a large cap equity allocation who traditionally would allocate funds to either an active large cap equity manager or an index fund. Despite having low expectations for alpha generation from large cap equities, the investor still wants to have beta exposure to it. In addition, the investor wants to look at other asset classes – for instance small caps or GTAA in order to generate alpha. CSAM says that, assuming the separation of market risk — beta — and active risk — alpha is consistent with the investment policy, the investor could use a portable alpha strategy to obtain both large cap beta exposure and the potential for small cap or GTAA alpha. This strategy would involve firstly the investor posting collateral to secure the desired large cap beta exposure to the S&P 500 index. The investor would then post a similar amount to short the small cap benchmark, which would then hedge out the small cap beta’s contribution to active management. In the case of absolute return strategies like GTAA the lack of benchmark means there is no requirement to short it.
Finally the investor would place the balance of the asset allocation with a GTAA or small cap manager who would seek to add alpha above the large cap beta exposure.
This is just an example of how portable alpha strategies can help increase portfolio efficiency. CSAM highlights the fact that the building blocks for a successful portable alpha strategy – the liquid derivatives market, index benchmarks and increasing number of alpha strategies – have been around for some time – but the current high interest in this type of investments has been driven by the growing pressure on plan sponsors to meet their target return expectations.
Mathew O’Connor, senior vice president at Lehman Brothers says that for those wanting to implement a portable alpha strategy their source and choice of beta is very important, and it should be something that is readily available in a synthetic form.
“For example you might want to have a beta that is the timber market. Unfortunately there is really not a liquid derivative instrument that you can get for timber in a synthetic way, so that is not going to be a good choice for your beta,” Mr O’Connor says. However, he adds, there are many sources of beta, some of which can be customised, that come at a different range of cost.
Cost is no doubt very important and one of the most talked-about issues among investors considering these strategies. Mr O’Connor says that when looking at costs, investors have to consider two different aspects.
Opportunity costs
“You don’t want to think just about the headline cost number because that is really only looking at one part of the equation. You really want to look also at the opportunity cost,” he comments.
“You might look at one index whose cost is Libor plus 50, and you might think that’s very expensive,” he explains. “But if you look at the opportunity set, meaning what the average managers in that space are adding in terms of alpha, that might actually be very cheap.”
Mr O’Connor says that the ideal way of implementing these type of strategies really depends on the client’s level of sophistication. “The easiest way to do it is a turnkey solution, one where you buy either a fund share or a note that pays you the total return of some beta plus the total return of some alpha,” he says.
Whether investors opt to choose total return swaps, future contracts or any other portable alpha strategies, what is clear is that these strategies can play a very important role within institutional portfolios. But can portable alpha be considered the solution for solving the problems of pension funds with high return assumptions?
The answer is that portable alpha can really help some institutions but it is not the best solution for everyone.
“To me portable alpha is two things,” says Paul Ullman, president at Highland Financial Holdings. “One is a mechanism for the pension world globally to try and earn greater returns, because there is a global problem of underfunded liabilities.” But also, he adds, there is a separate issue regarding efficiency. “Portable alpha conceptually is a wonderful way to gain efficiency in an investment portfolio,” he says. “I think it is important to separate these two aspects.”
Whereas the benefits of portable alpha strategies are significant, not all investors will find this approach suitable for their investment portfolios. “My fear is that portable alpha is essentially set up to be the solution for pension fund problems and I think, sadly, quite a few will be disappointed over time,” says Mr Brown. “It is not that pension funds cannot do it, because with the right resources they probably can, but it is not for everyone.”
Proper implementation
In theory, the idea of being able to implement a portable alpha strategy would sound
attractive to any investor but in practice things can get really complicated which means smaller schemes might opt for a packaged solution that contains a portable alpha dimension in it, instead of putting in place an unbundled strategy.
“The idea is that if alpha exists in a particular asset class you can try and get it and then swap it to whatever structure suits your liabilities,” says Mr Brown. “But for many funds the hassle of doing that is what can potentially drive them to more structured solutions,” says Mr Brown.
“Doing it yourself is not impossible, but involves a lot of resources. Schemes have a lot on their plates and that might not be top of the list.” As schemes get larger, he explains, the potential benefit of using unbundled solutions also grows.
If properly implemented, portable alpha strategies can be an efficient and cost-effective solution to increase expected returns and improve portfolio diversification. Today, investors can choose from many different alpha strategies and also build beta portfolios to track a wide range of indices and markets. But before making any decisions investors need to make sure they understand the process, they are clear about the cost and the risks they are taking, and they have trust in the managers they choose.
“In any portable alpha [strategy] you are borrowing money at Libor or Libor plus,” says Mr Ullman. “So any plan sponsor who thinks about portable alpha has to consider the question of confidence in the managers.”
