The three-year bear market in equities focused pension fund minds on the need for benchmarks that closely match the liabilities of their schemes. The days of presuming that equities will produce strong positive returns over the long term have gone, or at least until the next bull market.
Unfortunately, pension funds cannot simply choose a bond benchmark and relax in the knowledge that these will meet the payment requirements for members. The bear market has left many pension funds with a shortfall between current assets and their liabilities; they need to gain some outperformance to eradicate the shortfalls.
One possible solution is the core/satellite approach. The criticism of this method, however, is that pension funds have limited access to fund managers that can potentially produce alpha (which is the skill of the fund manager in outperforming the stock market). It is argued that if an Australian manager could consistently produce alpha, a UK pension fund would not invest with him because it would not want exposure to the Australian stock market.
It is for this reason that the concept of portable alpha is gaining in prominence. Its prime objective is to strip-out market exposure and transport alpha onto benchmarks that match pension fund liabilities. While the concept has been around for many years in the US, pension funds and consultants in Europe are taking more interest because of this need to match liabilities and access new alpha.
The use of derivatives
Diane Knowles, director of strategic solutions of Schroder Investment Management, says the aim is to “benefit from the skill of a manager in adding value above a benchmark index while removing the impact of a benchmark. Techniques exist to surgically remove the alpha from one fund and graft it onto a different portfolio”. These techniques involve derivatives – either swaps or futures.
Oliver Bolitho, head of UK and Ireland business development for Goldman Sachs Asset Management (GSAM), says if a pension fund identifies, for example, a Japanese fund manager that it believes can consistently outperform the Japanese market, it can short the futures of say the Nikkei to hedge out the Japanese equity market risk.
The second step is to buy bond futures which most closely match the fund’s liabilities. The amount of futures of the Nikkei it sells and the bond futures it subsequently buys will be of equal value. Mr Bolitho says this takes away equity market risk for the pension fund.
All the pension fund needs is for the manager to outperform the Nikkei consistently to make a positive return regardless of whether the Japanese market rises or falls.
If it is not possible to short futures of the underlying index, pension funds can strike a swap agreement with an investment bank. For instance, Ms Knowles says there are no futures for the MSCI Europe index. Therefore, a pension fund can agree to pay an investment bank the total return of the MSCI Europe index and receive the return on the benchmark such as gilts, which would be a closer match to its liabilities. “The net result is a gilt return plus the equity alpha of the fund manager.”
Axa Investment Managers recently conducted research into the benefits of portable alpha. Joanna Munro, head of UK institutional and global consultant relations at Axa IM, says it looked at the probability of surplus changes over the next three years if defined benefit schemes maintain a static equity exposure. “For a typical plan with 60 per cent invested in equities, we estimate there to be a one-in-four probability that surplus will fall by 10 per cent or more.”
In contrast, Axa IM believes that if the defined benefit schemes of the top 350 companies in the UK adopted a liability matched portable alpha strategy, it would enhance surpluses by an average of 60 per cent.
In theory, any asset class can be used in portable alpha but it may not be possible to short futures in certain markets. The more transparent a market, the cheaper and easier it is for an investment bank to hedge their risk. Hedge funds are a natural choice for portable alpha because they are typically benchmarked against cash.
Therefore, there is no market risk and pension funds do not have to short a futures market. Ms Knowles of Schroders says that even with portable alpha it is advisable for pension funds to allocate to a diversified portfolio of managers and asset classes to spread risk.
Diversification, says Chris Woods, chief investment officer of hedge funds at State Street Global Advisers, is one of the main benefits of portable alpha. By stripping-out alpha from the strategic allocation, pension funds can access asset classes they might not ordinarily invest in, such as Australian equities or various hedge fund strategies.
Pitfalls and risks
The theory sounds great but there are practical problems and risks. The risks of using portable alpha include the fund manager failing to outperform the market, counter party risk when using swaps and if the portable alpha programme has not been structured properly.
The irony of portable alpha is that it works best for strategies where the underlying market is inefficient as this gives fund managers the best opportunity to outperform on a regular basis. But it is easier and cheaper to use derivatives on the most liquid and efficient markets, such as UK and US large caps.
Rolf Banz, chief investment architect at Pictet, says portable alpha is a lot easier to talk about than to implement. “In principle, by hedging your market risk, all you need to do is find a manager who can consistently outperform the underlying market.
“The problem is that there are costs involved in porting the alpha. These costs vary. For example, if a pension fund invests with an emerging market manager, it is not easy to use futures so it has to go to an investment bank to strike an over the counter deal. The spreads on this deal will reflect the lack of liquidity in the market. The danger is that the cost will use up a lot of the advantage of using the fund manager.”
Mr Banz estimates that the cost of portable alpha for a UK or US large cap equity manager is less than 1 per cent. But for emerging markets this would rise above 1 per cent and then there are custody costs and management charges on top of this. Mr Banz says over the long term, an emerging market manager would need to outperform the index by about 4 per cent or 5 per cent a year to make it economical for portable alpha.
He argues that if pension funds can find one “investment genius” who can consistently outperform markets then they do not need to diversify within portable alpha. Otherwise Mr Banz recommends diversification, but cautions against using fund of hedge funds. “This may be a layer of charges too far.”
Weighing up the benefits
GSAM’s Mr Bolitho agrees that if a manager simply delivers index-enhanced returns of about 0.75 per cent a year, then it is not worth pension funds using portable alpha. Depending on costs, an outperformance of 2 per cent to 3 per cent makes it viable. The costs will partly depend on the liquidity and transparency of the underlying market and how often the fund manager trades his portfolio.
He adds that inefficient markets where managers can outperform are particularly attractive for portable alpha, such as Japanese equities. Another asset class often mentioned is currency, because it is perceived that active managers can add value.
According to Mr Bolitho, the portable alpha concept has been gaining ground over the past four to five years. In the past 18 months, consultants and pension funds have taken a closer interest and asset managers have won a handful of mandates.
Increasing demand
Nick Horsfall, senior investment consultant at Watson Wyatt, says there has been a small growth in interest from pension fund clients, particularly those who have exposure to index linked bonds to match liabilities. “We have had about five or six clients using portable alpha. It appeals to those using index linked bonds because they will not get much alpha from this asset class. There will be growth in demand in the future because of this,” he says.
“But so far a number of pension fund clients have been wary because of the use of derivatives in portable alpha. The counter party risk has been overplayed as institutions have used securitisation, which passes on the risk.”
Ralph Frank, senior investment consultant at Mercer Investment Consulting, believes portable alpha does add value for pension funds but it will be a slow growth. “We started talking to pension funds 18 months ago about portable alpha but said it would be a two to three-year education process. This is because of the use of derivatives and the complexity of the implementation of portable alpha.”
He believes the growth will come first through the bundled products that incorporate portable alpha and are being marketed by asset managers. As pension funds become more accustomed to the process, they will move to unbundled portable alpha arrangements using a range of “alpha generating approaches, such as long only and hedge fund strategies, combined with specialist transport implementers. It will take one or two high-profile pension funds adopting portable alpha-based approaches before it becomes widely considered.”
Knowles: ‘remove alpha from one fund and graft it to another’
Monro: ‘portable alpha could raise surpluses by 60 per cent’
