A“revolution’, a “paradigm shift”, something that will “alter the business of investing” and “turn investing on its head”. These phrases have all been used to hail the rise of portable alpha.
What is portable alpha and will it stand up to its billing? The idea hinges on the separation of the returns of assets invested in a benchmark, or beta, and those derived from the skill of an asset manager, known as alpha.
For example, if the stock market returns 10 per cent and a fund returns 15 per cent, 10 per cent of it is beta and 5 per cent is purely down to the fund manager’s skill, the alpha.
Pension fund portfolios have tended to task fund managers with outperforming a benchmark by establishing overweight or underweight positions relative to the benchmark. Such funds traditionally only invested in stocks within the benchmark and were therefore restricted. This also meant that the beta and alpha were bundled together.
By isolating beta from alpha (see figure 1 download file), funds can match their long-term liabilities by keeping the beta part of their portfolio but also seek higher returns from a wider range of assets and managers. This alpha can then be ported – or added back in – to the portfolio.
Types of portable alpha
Portable alpha products are available in various forms, either bundled, where the fund manager offers the beta and its own alpha products, or unbundled, where investors get the beta from somewhere else, or acquire it themselves.
Pension funds with fewer resources would tend to choose the former, whereas funds sophisticated enough to obtain their own beta cheaply may choose the latter.
A key element in capturing portable alpha is the use of exchange-traded derivatives. First it is necessary to secure your beta by buying an equity index or bond future which, through the use of gearing, can be bought at a fraction of the cost of the underlying product. This can be as small as 0.35 per cent for short duration bond futures and 8 per cent or more for equity index futures, which makes the capture of beta cheap and efficient.
Figure 3 (see below) shows just how much cheaper the average costs of trading are for futures versus the underlying cash product. This, and some additional points below, illustrate the major advantages behind the benefits of executing portable alpha strategies with futures:
- they are unaffected by capacity constraints and have low market impact;
- the market is fully transparent;
- daily, independent mark-to-market valuation;
- a central clearing house reduces counterparty risk;
- margin offsets available between benchmark/beta futures position; and
- using futures for your alpha gives additional leverage.
The process of purification is necessary because, while the investor wants the fund manager’s skill, he does not want exposure to the market that the manager is investing in.
For example, a European pension fund that needed to match its long-term liabilities could get that exposure cheaply by buying a European bond future, such as the Euro-Bond traded at Eurex. It could then choose from the entire universe of assets to get alpha, for example, from commodities, equities or hedge funds.
For one bond futures contract worth €100m, the investor would pay the initial margin of €1.4m, which allows him to leverage his capital. That is, for €100m exposure he only has to pay €1.4m to replicate the returns of his benchmark. He then has 98.6 per cent of his cash left to fund his futures position and buy his alpha.
Byron Baldwin, business development for Eurex, says: “The benefit for the institutional investor is that they pay next to nothing for their beta to match their portfolio with futures. They only pay for the alpha – the fund manager’s skill.
“Portable alpha is becoming absolutely huge. Now there is a major equity and bond future in every major marketplace in the world, the institutional investor can get beta from a benchmark return cheaply and efficiently using futures. And usually they are very liquid.”
The idea is particularly useful given the fact that pension fund solvency ratios are continuing to decline. This increases the pressure on funds to extract more from investment strategies to match liabilities.
Already in 2003, research by Axa Investment Managers found that the defined benefit pension schemes of the top 350 companies in the UK would improve their returns significantly if they adopted a liability-matched portable alpha strategy.
Indeed, pension funds have caught on quickly to portable alpha (see figure 2 download file). In November 2005, the US Securities and Exchange Commission estimated that US investors had increased their exposure to portable alpha by 15 per cent a year over the previous five years. And recently, Swedish pension fund AP7 demanded more products from the investment industry to help funds separate their alpha and beta.
Eleanor de Freitas, head of index strategy at Barclays Global Investors, recently said that use of alpha beta separation was growing. “We expect separation to take place more and more, with people going into passive beta strategies to deliver the core beta performance for their overall strategic benchmark choice. Analysis has shown that you are buying a lot of beta when you buy some active strategies. Your management fee might be better spent in getting an index provider to deliver the beta portion, and then have an active manager focused purely on delivering alpha.”
Increased sophistication
The application of alpha strategies is gradually becoming more sophisticated as well. A study carried out for Eurex by the Centre for International Securities and Derivatives Markets (CISDM) has found that using equity index futures contracts as overlays can benefit portable alpha programmes. The study looked at the performance of programmes using convertible arbitrage, distressed securities, emerging markets, equity long/short, equity market neutral, event driven, global macro, merger arbitrage and managed futures strategies.
Analysis was conducted for the period 1992-2005 using the DAX index and for 1998-2005 using the DJ Euro Stoxx 50 index. It found that in most cases portfolio performance was enhanced. For example, a broad based hedge fund portfolio, combined with DAX futures to provide beta exposure, would yield an annualised return of 11.66 per cent. That is more than 300 basis points higher than the return on the DAX index of 8.54 per cent for the same period.
A broad based hedge fund portfolio, combined with DJ Euro Stoxx 50 futures would yield an annualised return of 9.13 per cent – almost 200 basis points higher than the return on the DJ Euro Stoxx 50 index of 7.31 per cent, for the same period.
Considerations
There are a number of important considerations when conducting a portable alpha strategy.
First, because it involves futures, one must have a structure in place to manage the cash in the deposit on your futures position.
Many managers offering portable alpha products will manage the money on behalf of the pension fund.
Second, it is important for the alpha generating asset to be uncorrelated with the benchmark. This may not be as easy as it sounds. A number of pension funds view hedge funds and funds of funds as their primary source of alpha return within their asset allocation.
Mr Baldwin says: “Hedge funds can generate alpha, when they get a return that is uncorrelated to the benchmark of bonds or equities. Relative value and arbitrage hedge funds work well because the returns are unrelated to bond or fixed income. Foreign exchange is also becoming attractive as an alpha investment.”
Another consideration is tracking error. Futures are used to obtain market exposure to replicate the benchmark. The closer the relationship in the futures contract to the investor’s benchmark, the lower the tracking error.
Roll risk can occur because futures are usually delivered quarterly. To maintain the beta benchmarking exposure as each delivery approaches, you need to switch from one delivery month to the next which incurs costs. As the spread between two futures contracts moves, changes in the spread will affect the performance of the beta investment.
It is important to remember that there is a cost to extracting the beta from an alpha investment. Investments which can do this cheaply, or indeed have no beta element, are the most attractive portable alpha vehicles.
Reward
Institutional investors are faced with a world of low interest rates and low equity returns. By separating alpha and beta investment, and obtaining their benchmark investment cheaply with the use of futures, an institutional investor can concentrate on sourcing alpha returns. This also allows him to port the skills of any asset manager to its benchmark portfolio.
The question is, to what extent will the institutional investor adopt the new investment techniques? In ‘Freeing Alpha from Beta: Enhancing Portfolio Returns with a Portable Alpha Program’, Phil Green of Merrill Lynch Investment Managers, suggested: “For those who can accept and adapt to the new investing environment, the reward may be enhanced performance in a lower return environment.”
IN ASSOCIATION WITH EUREX , the world’s leading futures and options exchange.
Eurex is the world’s leading futures and options exchange and features open, democratic and low-cost electronic access globally. Eurex offers a broad range of international benchmark products and operates the most liquid fixed income markets. With market participants connected from 700 locations worldwide, trading volume at Eurex exceeded 1.25 billion contracts in 2005. Therefore, Eurex is the market place of choice for the derivatives community.
website: www.eurexchange.com
e-mail: Info@eurexchange.com
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