Portable Alpha: Bridging The Gap
By: Edward Kung & Lawrence F. Pohlman
With the high-flying days of the 1990s fast becoming just a memory, money managers are looking for methods to extract as much return as possible from their investments. Edward Kung & Lawrence F. Pohlman, of Panagora Asset Management, look at using portable alpha to achieve this goal.
Portable alpha takes the non-market, active return (or alpha) from a portfolio and transports it to other portfolios to generate returns that are unavailable from traditional investment strategies. Portable alpha strategies can be combined with any index, active strategy, or asset class to control risk and/or shape returns and they can be implemented within or across asset classes.
Investors can implement portable alpha through equitization that allows the plan to maintain asset class exposure while maximizing alpha generated from security selection without changing the plan’s strategic asset allocation policy target.
As well, it enables the investor to transport alpha to any asset class via futures overlay.
Most investment managers will tell you that the highflying days of the 1990s are just a memory. For the next several years, few managers expect double digits in equity markets and nearly all are calling for substantially lower fixed income returns. In fact, a plan with a standard 60 per cent equity allocation and a 40 per cent fixed income allocation is expected to return around six per cent to eight per cent per year over the next several years. These low return expectations present a significant problem to many under-funded pension plans.
To bridge the gap between the assets and liabilities, portable alpha strategies provide an efficient method to budget risk and enhance return with little or no incremental risk.
Furthermore, creativity and innovation in the investment management community is at an all-time high, allowing for the development of flexible strategies that are excellent candidates for portable alpha.
So, What Is Portable Alpha?
Active investment managers provide two types of return – the return generated from market exposure or ‘beta’ and the return that comes from selection skill or ‘alpha.’ Active ‘beta’ returns typically come from market timing – that is, increasing market exposure in up-markets and decreasing it in downmarkets.
Passive beta returns come from index fund exposure. ‘Alpha’ comes from security selection within an asset class. As such, the value-added from a true alpha strategy does not depend upon the direction of the market. A true stock-picker, for instance, would have a beta of 1.0 relative to their market benchmark, and all value-added would come from their ‘active risk’ or stock picking. Portable alpha refers to the process of separating the alpha from the beta and then applying it to other portfolios.
A portable alpha strategy is a beta neutral portfolio that is implemented through an overlay or by strategic asset allocation. Within strategic asset allocation, a plan can have: an outright allocation to portable alpha a capital commitment to portable alpha strategies while using futures or swaps to maintain the existing overall asset allocation (sometimes referred to as equitization)
Within these broad groupings, portable alpha can be generated many different ways. For example, an alphagenerating portfolio consisting entirely of futures uses very little cash (due to margin requirement) and provides an alpha that can be applied over all or part of the portfolio. We will refer to strategies that use little or no cash as ‘overlay’ strategies.
Alternatively, plan sponsors can invest in a portable alpha strategy where the investment manager purchases securities and uses derivatives to remove market exposure. For example, a manager of small cap equities who generates four per cent alpha each year can hedge the small cap market exposure, or beta, by selling Russell 2000 Index futures against the portfolio. This results in a pure alpha return that can be applied to the overall portfolio.
Implementing a portable alpha strategy requires careful consideration. In theory, most investment strategies can be converted into portable alpha provided there is alpha to begin with. The first consideration is liquidity. Ahedging vehicle is required in order to eliminate market exposure. In other words, there needs to be an available index future, swap contract, or ETF to be used for hedging.
Some investment strategies, such as real estate or private equity, do not lend themselves to constructing portable alpha due to the lack of a hedging instrument. Secondly, we need to be aware of the amount of ‘alpha’ that can be generated. Efficient asset classes will not lend themselves to generating enough alpha to be worthwhile.
The actual steps in building a portable alpha portfolio are straight-forward. First, a portfolio is constructed to beat the benchmark. Second, the market exposure of the portfolio is hedged out. Finally, the remaining alpha can be combined with another different market portfolio that is the goal of the investor. While the steps sound simple, there are many details to consider.
Why Do You Want Portable Alpha?
Many plans are currently facing significant funding shortfalls. Pension plans, insurance companies, and endowments all have anticipated payment streams that they need to fund. In order to meet these liabilities, their existing pool of assets must achieve higher returns than those currently forecasted or more cash will need to be contributed to the asset pool. Since most plans are reluctant to contribute additional cash, risk budgeting has been moved to the top of many agendas. Portable alpha enables investors to control risk and to shape returns while keeping their asset allocation essentially the same.
We will attempt to illustrate how investors can implement portable alpha using the following examples.
Case Study One – US Large Cap with Small Cap Portable Alpha
There are many different ways to source alpha. Exhibit 1 shows the median alpha (defined as the mean of the excess return of the manager over beta times benchmark return) and active risk for a number of traditional long-only strategies. The median US large cap manager has generated 0.58 per cent alpha in the last 10 years. This compares to a 3.78 per cent median alpha for US small cap managers. Clearly, small cap managers have added more alpha. Suppose that liability streams require a long-term exposure to the large cap market, a solution is to transport small cap alpha while maintaining the large cap domestic equity exposure.
We have constructed a hypothetical pension plan’s asset mix (36 per cent S&P 500, 23 per cent non-US equity, 21 per cent Lehman Aggregate, seven per cent non-US bond, eight per cent real estate, and five per cent cash). In addition, we utilized a small cap manager to provide us with portable alpha. The small cap portable alpha can be funded by reducing the large cap allocation from 36 per cent to 26 per cent.
Assuming the 10 per cent reduction in the large cap allocation is equal to $1 million, the basic investment process is as follows:
Step 1: The investment manager deposits $50,000 (five per cent of the $1 million) to satisfy the margin account with a broker. This allows for the purchase of $1 million in equity index futures, leaving $950,000 to be used for investment.
Step 2: The investment manager buys S&P 500 index futures to establish market exposure equal to $1 million to bring the large cap asset class allocation back to the original 36 per cent.
Step 3: The investment manager purchases $950,000 in small cap stocks. This portfolio is designed to beat the Russell 2000 index, but it has a beta of 1.0 relative to the index. The securities are custodied by the broker.
Step 4: The investment manager shorts $950,000 worth of Russell 2000 Index futures to eliminate the small cap market exposure or beta. The result is that the plan sponsor is able to maintain the original 36 per cent strategic domestic equity market exposure (original 26 per cent + 10 per cent S&P 500 Index Futures) plus the small cap portable alpha (see diagram).
Portable alpha allows the investor to maintain large cap equity exposure while utilizing alpha generated from small cap security selection.
Exhibit 2 illustrates how portable alpha would work. We assume that the small cap manager can generate four per cent alpha from stock selection. The large and small capitalization sectors represented by the S&P 500 and Russell 2000 indexes generated 27 per cent and 18 per cent respectively for the three years ending March 2000.
S&P 500 Index Futures would gain roughly $270,000, as the market went up 27 per cent during this period. As the Russell 2000 index went up 18 per cent, small cap stocks would gain $209,000 from the combination of market impact and alpha. The portfolio also would lose $171,000 from shorting the Russell 2000 index futures. The difference of $38,000 ($209,000 minus $171,000) represents a four per cent small cap alpha. Since the alpha is portable, it is applied to the original $1 million resulting in a 3.8 per cent active return. As you recall from Exhibit 1, the median large cap active manager would only have added 0.53 per cent.
Case Study 2 – Fixed Income Futures Overlay without Committing Capital
The portable alpha strategy in Case Study 1 relied upon equitization – the ability to overlay a manager with futures in order to change the market exposure. Portable alpha strategies implemented through equitization can provide great flexibility. However, a scarcity of capital may constrain strategic allocation portable alphas. Alternatively, overlay strategies enable investors to transport alpha with a minimum amount of capital.
Here’s an example showing how alpha can be generated via a fixed income futures overlay. The sample fixed income portable alpha strategy is an all futures based portfolio that seeks to deliver one per cent of pure alpha per year and takes no credit, duration, or convexity risk.
For this example, using the same plan’s asset mix, let’s assume the 21 per cent of fixed income asset class represented by the Lehman Aggregate Index is equal to $100 million. In practice, we need to satisfy only a three per cent margin requirement to trade fixed income futures. The investment process is as follows:
Step 1: The investment manager deposits $3 million, or three per cent of $100 million, to satisfy the margin account with a broker.
Step 2: The investment manager employs the futures based fixed income portable alpha strategy on a Lehman Aggregate portfolio with market exposure equal to $100 million.
Exhibit 3 illustrates how portable alpha works through a fixed income futures overlay. The index portfolio provides a market return. This is combined with T-bill returns and the return from portable alpha. In this hypothetical example, the plan would benefit by an additional $3,224,130 (one per cent compound on $3 million for three years, assuming one per cent pure alpha is delivered annually) from portable alpha with a minimum amount of invested capital. In this case, the portable alpha overlays the fixed income portion of the plan. Investors can tailor the overlay to cover all or part (50 per cent, 150 per cent) of the portfolio based on their investment objectives.
Portable alpha strategies employ some of the best financial engineering tools available to investment managers. These strategies allow them to shape returns and to control risk.
Portable alpha is more than a concept. We firmly believe that a properly executed portable alpha strategy will have profound impact in active alpha investing and will be broadly applied in traditional portfolio management.
Edward Kung is senior manager, product development, and Lawrence F. Pohlman is director and head of research at Panagora Asset Management. (firstname.lastname@example.org & email@example.com)
Characteristics Of A Successful Portable Alpha Program
There are considerable benefits of transporting alpha within or across asset classes. Successful portable alpha programs enable institutional investors to:
- Increase returns while maintaining a similar risk profile.
- Maintain a strategic asset allocation and provide flexibility to rebalance portfolios with index futures. In the case of the large cap-small cap example, investors can adjust the 10 per cent S&P 500 Index futures to shift their asset allocation.
- Transport alpha via an overlay program that is supported by a small amount of cash in a margin account. Not make wholesale changes to the existing manager structure.
- Clearly measure portable alpha performance. Through equitization, institutional investors can combine traditional asset classes with portable alpha (large cap equity + S&P 500 Index futures + small cap portable alpha) and measure performance against an appropriate broad market index such as the S&P 500 Index.
Alpha Program Successful portable alpha implementation depends upon an investment manager’s ability to generate consistent alpha. In addition, a number of issues may prevent institutional investors from implementing portable alpha strategies:
- Investment guidelines – A portable alpha strategy typically involves derivatives and leverage to hedge market risk. While some institutional investors have mandates permitting derivative usage, many do not.
- Lack of expertise – Institutions may not have the internal expertise to build and to execute a portable alpha strategy.
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