The Alpha Edge
When traditional investment methods prove unsatisfactory, a portable alpha strategy offers endowments one way to outperform a benchmark index.
By Don Fehrs
In truth, not everyone can consistently outperform, and even well-conceived strategies can disappoint due to the vagaries of financial markets. In my experience, the questions to ask center on whether your institution’s portfolio is—or should be—designed to outperform the indexes in some or all of the asset classes it contains, and, if so, whether you have a plan that is carefully constructed to give your portfolio a good chance of outperforming. Depending on your investment objectives, exploring the possibilities of a portable alpha strategy and explaining them to your investment committee may be well worth the time and effort.
Portable Alpha Defined
In designing a portfolio, trustees and investment staff often use their own estimates or data from consultants to forecast the rates of return and volatilities that they might expect in each asset class. Most of these estimates are based on averages from a historical index that represents the asset class. For example, the long-term annual return and standard deviation on the Standard & Poor 500 Index (S&P) have been approximately 10 percent and 15 percent, respectively. Investors might start with those as forecasts, then raise or lower the figures if they are optimistic or pessimistic about the prospects for U.S. stocks. Expected returns on bonds are lower, with less volatility, and there are many other asset classes—both domestic and international—from which to choose.
Portable alpha conjures up images of highly complex and sophisticated financial engineering techniques. Entire investment conferences are formed to explain the idea, its structural aspects, and its practical benefits. Simplified, portable alpha is a technique to outperform an index in any asset class in which more traditional methods for outperforming are unlikely to work or are difficult to implement. Two basic definitions help clarify the concept.
- Alpha is the term given to the outperformance above an index rate of return in an asset class. If you know an investment manager who consistently outperforms the S&P by 3 percent per year with a portfolio of stocks not too different from the S&P in characteristics, that manager has alpha of 3 percent. Importantly, it’s not a good indicator if the manager generates the high returns by holding all small-cap stocks, which historically outperform the S&P with higher volatility. That’s simply a bet on small-cap versus large-cap, not an indication of the manager’s stock-selection skill, or alpha. Even among the best managers, alpha will vary from year to year and will sometimes be negative; but, if the average performance is positive and significant, the extra investment return it represents will help your institution achieve its financial goals.
- Beta is the term for the return, over and above the risk-free rate, earned by investors in the index of a risky asset class. Again using the S&P as an example, if the index has a return of 10 percent per year over the long run, while the risk-free rate is 4 percent, the average beta for the S&P is 6 percent. In a single year, beta can be a large negative number (-23 percent in 2002) or a healthy positive (27 percent in 2003).
The distinguishing feature of a portable alpha strategy is that the investment sources of alpha and beta are separate. Instead of obtaining beta the traditional way, investing cash in an index fund or with an active manager, the investor acquires beta through derivative contracts such as swaps that require little or no cash to establish. This method of obtaining beta is sometimes referred to as synthetic beta. The cash that is designated for the asset class is then invested in a separate alpha-generating vehicle that often uses securities from an entirely different asset class. The combination of alpha and beta from this strategy may be superior to what you could attain by more traditional means.
The concept of portable alpha has been around for many years and has variations, including enhanced indexing, which might be more familiar to some investors. Portable alpha and enhanced indexing share a common premise, and there is no clear separation between the two. For instance, PIMCO’s Stocks Plus strategy, launched in 1986, is often referred to as enhanced indexing and uses the exact same principles as portable alpha. In general, enhanced indexers take less risk and shoot for lower alpha returns than portable alpha managers. PIMCO’s original Stocks Plus Fund targeted excess returns less than 1 percent, with low risk, and used the S&P as the underlying index. PIMCO has since developed alternative versions of the strategy with higher return and risk expectations and a variety of indices.
In 2005, former Harvard Management Company CEO Jack Meyer left Harvard with some of his colleagues to form Convexity Capital and in 2006 launched the firm’s hedge fund. Convexity’s fund uses the technique of portable alpha to help clients outperform a benchmark index that they choose from a list (S&P, EAFE, Lehman Aggregate, and others) and targets a level of annual alpha return around 4 percent. (Convexity raised $6 billion, mainly from endowments, so the launch of Convexity significantly elevated the strategy’s profile within the endowment community.)
At the time, I was chief investment officer at Cornell University. I recommended, and the university’s investment committee approved, an allocation to Convexity with the Dow Jones-AIG Commodity Index as the benchmark. My primary reason for choosing commodities for this portable alpha application was the dearth of active managers with substantial track records in that asset class. Not surprising, the single, most popular choice of benchmark among investors in Convexity was Treasury Inflation-Protected Securities (TIPs), in which long track records and variety and volatility in the asset-class securities are lacking.
The traditional method of seeking alpha across different asset classes is to hire investment managers who skillfully choose securities within that asset class. If that method works, it’s hard to argue that any alternative method is needed. But many investors have found the traditional method difficult or disappointing. Different types of obstacles interfere with the success of the traditional method.
|In Case You’re Wondering…|
Among the benefits of a portable alpha framework is the fact that changes to your asset allocation can be more easily and inexpensively made than if you use traditional managers. Assume you want to increase your international equity exposure while reducing domestic equities. With traditional managers, you would need to liquidate the domestic equity portfolio and reinvest the cash proceeds with an international manager, incurring investment costs on all the individual securities on both sides of the trade. In a portable alpha program, you simply change the swap or futures contracts involved from domestic equity to international, leaving the alpha-generating process in place.
In discussions about portable alpha several questions often emerge.
Is it really alpha? Some investors may be tempted to use a general, multistrategy hedge fund as their alpha engine. This might produce a satisfactory result, but most multistrategy hedge funds take on a variety of beta exposures while seeking additional alpha returns. If the alpha vehicle you’ve chosen is tainted with beta exposures, you’re transporting something, but it’s not pure alpha. In such instances, carefully consider whether these additional beta exposures are desirable in the context of your overall portfolio.
Is this expensive and complex? The costs you incur for creating the beta exposure through a swap instead of with traditional managers will vary depending on, among other factors, the index you’ve chosen, the amount invested, and whether you do it yourself or have an investment manager do it for you. If the alpha engine you’re using produces significant positive results over time, it will more than overcome implementation costs. The complexity of most swaps is no greater than that involved in the generic fixed-for-floating interest rate swaps used by many institutions to fine-tune their debt portfolios.
Don’t hedge funds and other alpha engines charge high fees? Unlike traditional managers, who generally charge a fee equal to a percentage of the assets under management (0.5 percent to 1 percent is common), hedge fund managers receive both a standard asset-based fee (1 percent to 2 percent is common) and an incentive fee (normally 20 percent of performance). To provide alpha to investors, hedge fund managers must overcome these higher fees. Offsetting this disadvantage is the intense focus of the hedge fund manager on producing alpha, rather than the blended goals of traditional managers, who provide both alpha and beta in varying proportions. A modest fee paid to a traditional manager who is making only a modest effort to produce alpha might be a worse bargain than an incentive fee paid to a specialist manager who has no mission other than alpha production and is therefore entirely dedicated to that effort. As with any investment, assess all your alternatives on the basis of net-of-fee results.
What about counterparty risk? If you are using swaps, the portable alpha strategy will succeed only if the counterparty completes its side of the contract when called upon. To minimize any chance that this won’t happen, you or your investment manager will want to do business with a strong, reputable dealer to ensure a very low probability that the dealer will default on a future swap obligation.
Managers who hug the benchmark. In asset classes such as U.S. stocks, with long histories of well recorded data for investment managers, evidence shows that most managers tend to perform very close to the benchmark index, straying from the index by carefully measured amounts only. In most cases, it appears that managers want to provide a portfolio that reflects the beta of the asset class while adding a bit of outperformance, or alpha. A manager might have strong opinions about the technology stocks in the S&P and therefore actively overweight some of those stocks and underweight others, creating an opportunity for alpha. But, assume the manager has no strong opinions about the financial stocks in the S&P and thinks that all are at around fair value. If financials are the hot stocks of the year and lead the returns of the overall market, the manager is unlikely to avoid the financials sector, since a manager who avoids them will not have results that reflect the overall index return for that year. Typically, that manager will hold positions close to the index positions in the financials sector. That portion of the portfolio helps replicate the index beta but has no chance of producing alpha.
A system that offsets bets. Institutional portfolios often contain multiple managers in a single asset class, with a goal of prudent diversification, but those multiple managers won’t be coordinating their efforts to generate alpha. A large-cap stock manager might choose to underweight a certain type of technology stock in an effort to generate alpha. A second large-cap manager might overweight that same type of technology stock in an effort to generate alpha. One manager is likely to be right, one wrong, but the overall institutional portfolio has no chance to generate alpha, despite incurring fees to both managers for their offsetting efforts. Unless you have the resources to design your asset class portfolios to avoid these offsetting bets, it’s likely that your potential overall alpha is much less than you think.
A history of short track records. In asset classes such as emerging markets or commodities, with much shorter histories of well-recorded data for large numbers of investment managers, few managers demonstrate substantial track records of outperformance that give investors confidence in future success. While investors would like to see evidence of consistent performance through differing market environments, that evidence doesn’t yet exist.
Insufficient variety or volatility of securities. Some asset classes don’t offer enough variety or volatility among the securities in that asset class to hold much promise of alpha. If you have traditional government bonds as an asset class, investment managers have to choose from a fairly homogeneous pool of securities within the asset class widely thought to be efficiently priced. These managers might have a difficult time finding opportunities for alpha.
These common obstacles arise because in traditional portfolios the beta and alpha components of the investment return are packaged together. Managers in some asset classes are unable or unwilling to put enough emphasis on the alpha portion to make the investment pay off significantly for the long-term endowment investor. In those asset classes for which you think traditional methods will not meet your institution’s objectives, the technique of portable alpha circumvents these obstacles by separating the two components of the investment return, using strategies that focus precisely on providing either beta or alpha, then combining the two components into a satisfactory package.
More Than One Method
Portable alpha can be structured using various methods and instruments. Two such methods include adding an alpha engine to an index exposure and replacing an unwanted beta.
Method 1: Adding an alpha engine to an index exposure. Suppose your asset allocation calls for TIPS in your portfolio. Yet, you agree that it’s difficult for a TIPS manager to find exciting, alpha-generating choices among the individual securities in that asset class. Using a swap contract, an investment manager or your institution can purchase the beta of a TIPS index portfolio at very low cost. This will use no cash until the swap contract is settled, which might occur at the end of each quarter or at the end of each year. The cash designated for the TIPS asset class can then be invested in a pure alpha strategy.
An example of a pure alpha strategy is a hedge fund focused on stocks, bonds, or currencies, where there is plenty of variety and volatility among the individual securities. To meet the definition of pure alpha, the hedge fund or funds should be market neutral—that is, the funds should be managed in a way that eliminates beta, or market risk, by going long and short in equal amounts of securities. In this case, the overall return of the chosen market (the beta) should have no impact on the hedge fund’s results. Only the stock selection skill, captured by the relative gain of the long portfolio versus that of the short portfolio, is what matters. (See Figure 1.) To diversify your alpha engine, you can choose multiple hedge funds or a “fund of funds,” in which each underlying fund is focused on a specific area of the global markets.
How does this portable alpha strategy avoid obstacles to outperformance? The market-neutral hedge fund alpha manager isn’t at all concerned with capturing the beta, or index return, of his or her asset class and doesn’t waste any part of the portfolio on stocks of little interest. Rather, the manager is solely focused on producing alpha. The beta you desire—in this case, TIPs—is provided by the swap agreement. Likewise, the alpha-generation process is unified within a single manager and won’t be offset by overlapping managers.
If you want diversification in your alpha portfolio, choose hedge fund managers with distinct sector, cap-size, or regional expertise or a fund of funds designed for this purpose. Even though the manager is helping the institution outperform a TIPS benchmark, with its short history, the alpha portfolio is using stocks, bonds, or currencies—and the manager might well have a long track record of successfully selecting these securities. Worth noting: The alpha portfolio should be chosen from a market that has plenty of variety and volatility and offers opportunities for shorting. Such a portfolio should have a significant chance for positive, or negative, alpha.
Method 2: Replacing an unwanted beta. For this method, suppose that a university’s portfolio includes a real-estate investment trust manager who consistently produces alpha above the REIT benchmark. However, the consensus opinion among the staff and the investment committee is that the REIT asset class is likely to suffer in the future from higher interest rates and the full real-estate valuations built into current prices. The staff, knowing that alpha is rare and must be fully exploited wherever found, certainly does not want to close the REIT account. The best solution is to consider the REIT manager as the alpha engine, then use a swap to replace the unwanted REIT beta with a more desirable beta, such as the S&P 500. The net result of this strategy is to receive the S&P 500 return, plus the alpha from the REIT manager, minus the cost of the swap. (See Figure 2.)
These examples show a couple ways to implement portable alpha. In another variation, futures contracts can be used as an alternative to swaps for achieving the desired beta exposure. For any version of a portable alpha program, proper cash management is essential, so institutions will want to be sure to have the resources to monitor expected payments associated with swaps or futures.
The Alpha Attraction
True alpha is difficult to find. Institutions are more likely to find it if searching for a pure alpha vehicle rather than for alpha that is mixed with other types of exposures. A greater variety of these alpha vehicles, many in the hedge fund or fund-of-funds format, are establishing longer track records with higher levels of consistency. If well designed, a portable alpha strategy has a solid chance of success because the investment managers who are part of the strategy have clear and specialized objectives and their efforts can be easily measured.
Institutions can obtain general market exposures, or betas, inexpensively by using swap contracts. The swaps used in portable alpha are similar to those already used by many institutions to adjust their interest rate exposure on debt. Futures contracts provide an alternative method of obtaining beta, and investment managers can provide a packaged solution, combining derivative instruments with their favorite alpha engine so that the total cost should be manageable.
As the portable alpha technique gains broader acceptance, implementation will become easier. Once all the issues of traditional management and portable alpha are considered, more investors will likely opt for the portable alpha strategy.
DON FEHRS is senior vice president and director of research, Evanston Capital Management, Evanston, Illinois.
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