In the four previous articles of the Derivatives Clinic, we studied how to improve the asset allocation of a pension fund’s portfolio using structured products. We considered a wide variety of underlying assets, from classic financial assets through to more exotic assets such as commodities. However, the analysis remained focused on beta-linked products. But what about alpha? It seems to be everywhere, judging by the number of market professionals referring to it all the time. Yet before we explore the contribution that banking products can make to the alpha quest, first let’s make sure we are all talking about the same thing.
Alpha is good, wherever it comes from
Traditional assets, such as bonds or equities, bear a beta exposure, that is to say that their returns are strictly linked to the market’s performance. Conversely, managed assets provide another source of return, called alpha, which is generated from selection and trading skill. Stock picking, dynamic sector or style allocation are examples of alpha sources in the equity world. Arbitrage that exploits market inefficiencies or pricing distortions is typically hedge fund-like alpha generation.
Alpha is, or was until recently, almost by definition linked to actively managed portfolios, while beta can be acquired passively, by taking broad exposure to the market.
In a popular view, alpha is a superior sort of asset compared with beta. First, it springs from outperformance relative to the rest of the market, and second, it represents a stable stream of returns, with little volatility and no market timing issues (which are the biggest nightmares of beta investors!)
That said, beta does bring value, in the sense that a risky asset such as equities is meant to outperform the cash rate over long periods. This is the “equity risk premium”, which is real and does not depend on manager talent. And there is only one way to capture it – buy the asset.
A pension scheme seeking some beta exposure to UK equities would traditionally look for the “best” UK equity manager, i.e. the one who generates the most alpha. Instead, it could make at least as much sense for the scheme to acquire the beta passively at the lowest possible cost, and look for all possible sources of alpha, not limiting itself to UK equity funds.
Giving alpha some structure
The structured products industry, until recently, focused solely on re-engineering the risk profile of a beta exposure. It is now proven that an adapted structured products investment strategy can efficiently mitigate the downside risk in a portfolio context. However, an important new step in the industry has been made towards more direct exposure to the alpha itself, either through products indexed on a portable alpha strategy or through systematic strategies that, similarly to hedge funds, extract value from market patterns or pricing distortions.
With products such as portable alpha, the alpha is extracted from managed funds, whereby the stripping of alpha is achieved by going long the funds and shorting the benchmark. Where the structured product adds value is that is offers a dynamic management of any leverage provided on the funds and provides the investor with downside protection ensuring capital preservation whatever happens.
An example of a systematic strategy is the buy-write strategy, where the yield comes from a combination of portfolio dividend and writing call options on the shares held. These strategies generate alpha since their returns are not linked (or not totally linked) to the market’s performance.
Allocating the alpha
The real challenge with alpha is how to quantitatively assess its contribution to the portfolio. Hedge funds, for instance, can be a striking example. Hedge funds may be seen as a dream asset, outperforming Libor by a healthy percentage on a yearly basis, at a low volatility. Unsurprisingly, if put in an efficient frontier model with such risk-return parameters, results are tremendous: we should put all our money into hedge funds! Obviously, hedge fund investing is far from being risk free, simply the risk tends to materialise in a violent but infrequent manner.
This is really the difficulty about using alpha-generating assets in an optimisation framework – their dynamic behaviour is completely different from equities or bonds. The fact is alpha-linked returns have to be modelled specifically and require a flexible software to be optimised in a portfolio analysis. Once this is achieved, an efficient frontier analysis can now be conducted on portfolios including structured products on alpha. As expected, including a structured product on alpha in a portfolio composed of bonds, equities and real estate significantly improves its efficient frontier (see figure one).
Figure One: Improving the Efficient Frontier
At the conclusion of our series of articles, it is clear that there is definitely a part of any investor’s (especially pensions funds’) portfolio which should be allocated to risk controlled solutions – let it be in classic underlying assets, in commodities and in pure alpha.
Wojtek Nabialek is head of the Global Structuring Group at BNP Paribas London.
In association with BNP Paribas.
