To say portable alpha is complicated is to underestimate the sheer complexity of the process. Yet, despite this apparent hurdle, the ability to provide non-market correlated returns has become much more popular across Europe as institutions realise the need to generate excess alpha.
A low-yield environment combined with pension funds starting to separate their beta exposure from trying to gain alpha has seen portable alpha start to gain traction. With financial instruments such as swaps becoming more widely accepted, the notion of portable alpha has moved from the theoretical to a question of just how it can be applied.
“Portable alpha is now transitioning to the point where real mandates are starting to show up,” says Jeffrey Knight, chief investment officer at Putnam Investments. “The challenge facing pensions and institutional investors in generating sufficient returns has caused a rethinking of the way to build a portfolio.”
Brandon Horwitz, portfolio manager at Morgan Stanley Investment Management agrees – but with a caveat. “Portable alpha is gaining acceptance and service providers are coming out with more products,” he says. “But it is not quite mainstream yet.”
There is a sense at many European institutions that they should at least be seen to be talking about implementing some sort of portable alpha strategy. A hot topic at conferences and among consultants it has become a panacea expected to solve the twin problems of meeting accounting and regulatory requirements. Yet, for some, it remains purely at the theoretical stage. Ratan Engineer, global head of the asset management sector at Ernst & Young, is one such sceptic. “Portable alpha is certainly more talked about than implemented,” he says. “The idea behind the structure is a sensible one, but the elusiveness of alpha itself is such that to start talking about portable alpha just makes one's head spin.”
This is the problem many institutions face: any discussion of implementing a portable alpha strategy must be prefaced with talk of just how to generate alpha in the first place. “Forget about portable alpha,” agrees Mr Engineer. “The challenge is to find a manager capable of delivering alpha sustainably.”
Effectively, porting alpha means the removal of market exposure within a portfolio, leaving behind just the manager’s ability or alpha. Like many investment processes and ideas it was first seen in America, partly as a result of higher institutional equity exposure. “In the US our institutional investment strategy 10 years could be characterised as being very equity reliant,” explains Putnam’s Mr Knight. “In other words you will make your 9-10 per cent actuarial return because the stock market has gone up and because you have a lot of your money invested in stocks. This doesn’t apply so much in Europe.”
Continental institutions tended to place their faith in the bond markets – while the UK has always been closer to American investment styles. Portable alpha has not been so quick to catch on in Europe for several reasons: institutional investment strategies have tended to be slightly more absolute return orientated and the stock markets have performed well recently.
To a certain extent American institutions were driven to implement portable alpha out of necessity, which has been particularly prevalent over the last year. “The US stock market lately has been disappointing so there has been an urgency to evolve out of that playbook,” says Mr Knight. “Investing a lot of money in stocks and waiting for the market to go up just wasn’t working.”
A similar recognition in Europe saw portable alpha strategies gain greater coverage. But the main problem for many is once the beta exposure is separated from the alpha, how to go about finding a good alpha fund manager?
“It is the key challenge,” agrees Mr Knight. “It is the hardest thing to solve. And it is difficult because it is not just a function of finding fund managers with a good track record. They have to be winning for the reasons they say they are winning. And that has to give me conviction that the performance will continue as opposed to just being the lucky monkey who just owns things that happen to go up.”
Ernst & Young’s Mr Engineer remains more bluntly sceptical: “There probably isn’t such a creature as a manager who can deliver alpha on a sustainable basis: if they could, they wouldn't need to manage other people's money.”
But for Morgan Stanley’s Mr Horwitz it is not necessarily a problem to find alpha, “but clients need to decide how much alpha they want and what they want to do with it”.
For him it is a question of understanding the underlying levels of risk inherent in such strategies. “You have to take risk to generate return,” he explains. “If you want to generate Libor plus 100 basis points then you will not be taking very much risk. If you want Libor plus 500 basis points then you are taking on quite a high level of risk and you have to be prepared to take quite a large fall in your assets to generate the returns you want.”
Risk is always going to be a key factor, with many convinced that anything to do with derivatives carries such ancillary risk that such strategies are worthless. But while often the opposite is true, because portable alpha strategies use derivatives to gain market exposure can this lead to unintentional leverage?
For Mr Horwitz this is a misunderstanding of the central issues. “Derivatives are very much intentional leverage,” he argues. “You shouldn’t be taking unintentional leverage because that would mean you don’t know what you’re doing.”
The whole point of adopting portable alpha is to keep risk under control, agrees Ernst & Young’s Mr Engineer. “It is about gaining an alignment between what the client gets and what he pays for. The extensive use of derivatives isn't necessarily for alpha generation but in getting cheaper access for the beta related portfolio.”
Maintaining a certain level of capital protection is also key, adds Emanuele Ravano, co-head of European strategy at Pimco Europe. “You don’t want to have a portable alpha discussion in which you are betting your capital as that takes you out of the game altogether if things go wrong. You don’t want to complicate things but just get back to the starting point.”
Yet for many institutions discussion of portable alpha and derivative-based investment strategies has represented a sea change in how they conduct their investment business. “I have seen plenty of continental pension funds hire risk managers in the last couple of years,” notes Peter Preisler, head of business development at T. Rowe Price.
The growing acceptance of the use of derivatives in financial planning has made talk of overlays and excess alpha commonplace, particularly within the context of the current liability-driven investment environment in continental Europe.
Mr Preisler believes portable alpha has been around longer than LDI, “but if you are using any kind of liability-driven approach which I hope most investors are, the first year when people were talking about LDI it was all about liability matching – now it is more like a framework.”
The liability-driven part means people are more aware of how to construct their beta exposure, he says. “They all know they need alpha, but if the beta exposure takes them to areas where they don’t expect to find that alpha then portable alpha techniques are areas on which you can build, and, hopefully if you are really good, find some alpha and then port it back to your beta.”
Certainly some of the larger American institutions have been using portable alpha for the last 20 years, notes Morgan Stanley’s Mr Horwitz. “But now it is slowly making its way into the mainstream. The key driver of this is that the derivatives to practically implement portable alpha are becoming much more liquid and much easier to use, and people are becoming more comfortable using them.”
A growing acceptance of LDI has brought with it a reduction in the misunderstandings around more complex financial strategies. “Portable alpha and LDI are very much two sides of the same coin,” agrees Mr Horwitz. “The original driver for LDI was that clients wanted to invest in fixed income or index-linked assets that match their liabilities. And the main challenge was that the bond assets were not available in the form they wanted. The initial LDI products were just a way of transforming bond asset or cash to have the type of duration they wanted, which was effectively a way of making bonds match clients’ liabilities.
But now institutional investors have realised that if you just invest in bonds – whether they are tailored LDI bonds or old-fashioned bonds – you are not going to get the kind of returns you need to pay pensions.
“LDI allows you to synthetically gain the interest rate and inflation exposure you need to match your liabilities without committing capital,” continues Mr Horwitz. “That is the key strength of an LDI strategy that uses swaps. If you enter into an LDI strategy you can use swaps to get that exposure and put your capital into an investment that gives you a better risk-return trade off.
“Doing one thing with your capital and being portable with what you do with the exposures links LDI and portable alpha together.”
