A Portable Alpha Primer
By: Bruce B. Curwood
The added complexity and, in some cases, potential for added risk has kept many pension committees from buying into high alpha strategies and approaches, despite their need for higher returns. Portable alpha may be the answer, says Bruce Curwood, of Russell Investment Group.
These days, investors know good beta is hard to come by. Beta, defined as the level of exposure an investment portfolio has to capital markets, has become much tougher to generate than it was in the heady, high-return environment of the late 1990s. Back then, investing passively in, say, a large cap index fund yielded more than enough return to match the average plan sponsor’s liabilities.
Since then, weak returns from traditional allocations to asset classes like stocks and bonds have lead many institutional investors – including plan sponsors – on a quest for new and better sources of return. That’s why adding value through skilled active management, or ‘alpha,’has become more compelling for investors.
In recent years, plan sponsors have been kicking the tires of high alpha investment strategies such as alternative investments (hedge funds, private equity) and non-traditional approaches to asset allocation (overweighting a portfolio with high alpha investments such as small cap stocks). But while high alpha strategies and approaches can help boost returns, their added complexity and, in some cases, their potential for added risk, have kept many pension committees from buying in.
This is why portable alpha strategies appear to be a good solution. Designed to combine optimum market exposure with the richest sources of active management, portable alpha strategies aim to give investors the best of both the alpha and beta worlds. In an ideal situation, they offer a significant benefit to plan sponsors. However, without the right conditions in place, the costs of a portable alpha strategy might not add up to the promised benefits. How can you determine whether portable alpha is right for your plan? And what factors must you consider before taking the plunge? The answers to these questions might not be as easy as you think.
The Ins And Outs Of Alpha
To understand how portable alpha works, let’s start by looking at how the average pension portfolio is constructed – the fund’s asset mix policy. Plan sponsors looking to meet their liabilities over the long-term, aim to diversify among several asset classes (stocks, bonds, etc.), to generate sufficient return while maintaining an acceptable level of risk. Most Canadian plan sponsors have tended to invest in traditional asset classes (global and domestic stocks, bonds, etc.) with the vast majority adhering to an asset class exposure of 60 per cent to equity markets and 40 per cent to bonds. In that mix, alpha and beta have long co-existed. Plan sponsors seek long-term investment returns through exposure to traditional capital markets (beta) along with a boost from active mana g e m e n t (alpha) to add value. Basically, the equation is ‘alpha + beta = investment return.’Here, active management typically can add about 15 basis points (bps) in value to a bond portfolio and possibly upwards of 150 bps in value to an equity portfolio.
This traditional approach to the alpha/beta mix is fine when capital markets are performing well and there’s enough beta to go around. But, when the beta starts to slide, as it did during the bear market of 2001 and 2002, it’s time to take a closer look at the alpha side of the portfolio.
High alpha approaches are designed to increase portfolio return by exploiting different ways of risk-taking. The potential for added value from active management is often three to six times that obtained from traditional asset classes such as large cap stocks. Such approaches add value by investing in less liquid areas of the market, increasing opportunity through leverage or shorting stocks, and taking advantage of market inefficiencies by obtaining proprietary information such as legal inside information.
Unlike traditional approaches, non-traditional and alternative strategies have the potential to generate more added value because the markets they deal with are less mature and/or robust than, say, a U.S. large cap equity fund. For example, in a traditional approach or strategy, identifying key pieces of information or market inefficiencies is very difficult when information is readily available to all in a public market. By contrast, non-traditional and alternative approaches offer more room to exploit inefficiencies through active management.
The Risk Factor
Given the potential rewards, why don’t all plan sponsors take a high alpha approach to asset allocation? The problem lies in the added risk that alternative investments and non-traditional approaches bring. In addition, publicly available return data for alternatives such as hedge funds have limited history, often plagued by survivor, back fill, and stale pricing biases. These problems often limit investor confidence. Alternative strategies and non-traditional approaches can also be difficult to understand, requiring time, resources, and internal expertise that many plan sponsors can’t provide.
By comparison, traditional investments in a portfolio present more of a known quantity for pension committees concerned with minimizing risk – markets are robust, deep, and liquid, plus returns are built on daily data that goes back decades. The result is if, and when, plan sponsors make room for high alpha in their portfolios, they tend to limit their direct allocations to just five or 10 per cent in the interests of prudence. Clearly, this alpha alone isn’t enough to help plan sponsors sleep at night confident their liabilities will be met.
So is portable alpha the answer? In response to the traditional approach, new strategies have emerged claiming to better balance the risk-reward equation. That’s where portable alpha comes in. It aims to keep an investor’s exposure to traditional capital markets constant, meaning the beta remains about the same. The difference is more alpha is added by replacing the active management portion of the portfolio with non-traditional approaches or alternative investment strategies. Additionally, derivatives are utilized to eliminate any supplementary beta exposures incurred by investing in higher alpha strategies.
In summary, portable alpha attempts to give investors the best of the alpha/beta worlds by maintaining the same passive exposure to major stock and bond markets (beta) that traditional investment policy demands, while incorporating higher active, value added strategies to increase alpha. Essentially the alpha is transferred, or ‘ported,’ from a non-traditional or a high alpha investment strategy to the total fund level while ensuring the beta remains constant.
Theory Versus Practice
On the surface, this sounds like a relatively simple approach. Alpha and beta are maximized and the investment committee can sleep at night, right?
Well, not quite. In an idealized world, portable alpha will likely improve the performance of an investor’s portfolio with little risk of harm. However, real world problems – such as implementation costs and obtaining the expected manager value added – are common issues that can arise all too easily. And when it comes to pension plans and portable alpha, size, expertise, and resources are key. A corporate treasurer managing a typical $500 million pension plan might not have the necessary skills and resources to properly implement and maintain such a strategy.
The challenge lies in the complexity of the strategies and the way they are set up. Portable alpha strategies come in many flavours – the sources of alpha and hedging instruments employed are nearly limitless.
For the purposes of this article, however, let’s look at what it would take to implement a typical portable alpha strategy. In such a case, an investor will need to take the following steps:
- Liquidate their existing fixed income and/or equity investments
- Purchase collateral and establish a margin account to support the futures position used to port the alpha
- Invest the remaining proceeds with the non-traditional higher alpha manager
- Take short positions in a variety of equity index futures and currency forward contracts to offset the market exposure of the basket of the non-traditional higher alpha manager
- Take long positions in a basket of fixed income and/or equity futures to reestablish a passive (beta) exposure to the original fixed income market
Does this sound more complicated than the simple, conceptual approach we previously outlined? In reality, portable alpha strategies involve a great deal of complexity to implement. You also need to make sure that the costs do not outweigh the potential benefits of the strategy within the context of your fund.
The Costs And Pitfalls Of Porting Alpha
Along with the upfront and ongoing costs of implementing a strategy, the costs of porting the alpha can add up fast. For example, there are the direct costs of:
- purchasing the futures/forwards
- monitoring for tracking error
- the effects of dilution due to margin requirements
A recent Russell research paper estimates that one portable alpha strategy with 280 bps in alpha (net of manager fees) would add as little as 10 bps at the total fund level, even if the expected alpha targets for active management held.
The complex nature of portable alpha strategies goes beyond costs alone. Derivatives are key to porting alpha and if there is no liquid derivatives market available, then the strategy won’t work. Markets must have the depth and breadth to support the necessary derivatives (futures) positions.
Importantly, good managers are hard to find, particularly when it comes to high alpha strategies. You need to ask key questions and determine whether the stated alpha expectation of the non-traditional strategy is real or perceived. Returns are often subject to many biases, meaning the value derived from active management is often reported incorrectly. In many cases, the added value is actually a result of market influences (beta) rather than manager skill. Make sure you can tell your alpha from your beta. That will help ensure the alpha is not being overstated or that the beta in your portfolio is held relatively constant.
In addition, ask whether or not the manager’s strategy is sustainable. In far too many cases, the alpha generated through successful alternative strategies could have come from specific market circumstances that might not recur in the future. Or, they might be from arbitrage strategies that no longer exist. The high levels of alpha of the past may not be there in the future. A high alpha strategy needs to have some predictability and persistence in performance. If not, any attempts to port it will most certainly fall short of expectations.
Is Portable Alpha For You?
While it’s clear that portable alpha could have many benefits, implementing such a strategy without knowing exactly what you’re getting into is not advisable. Remember, first and foremost, you need to have access to the resources, expertise, and time to make sure this is done well. And you need to make sure a skilled manager is in place. In short, portable alpha strategies aren’t for everyone. Fiduciaries need to know what they’re getting into and understand the risks before they make the jump.
Bruce B. Curwood is director, institutional solutions, for the Russell Investment Group.
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