Generally speaking, portable alpha consists of extracting and transferring the added value arising from active management (alpha) onto the returns obtained by passively investing in a given market (beta).
Generally speaking, portable alpha consists of extracting and transferring the added value arising from active management (alpha) onto the returns obtained by passively investing in a given market (beta).
The process permits a separation of the choice of beta from the choice of alpha. For example, an investor could transport (or port) the added value generated by a Canadian equity manager onto a portfolio that replicates exposure to a Canadian bond index, thus increasing the overall return of the bond portfolio (see graph below). Consequently, portable alpha allows investors to make mutually exclusive choices concerning the sources of beta and alpha. Traditionally, the two have always come from the same market source.
The objective is to increase the portfolio return that would be obtained under an index strategy, but also to obtain an added value that is higher than would have been generated had the alpha come from the same source as the beta, without increasing risk.
There are several important elements to ensuring the success of such a strategy, the two most important being the quality of the underlying source of alpha and the successful replication of the desired beta exposure.
Alpha Sources
The alpha source is without doubt the key consideration in all portable alpha strategies. Alpha sources can be divided into two main categories: traditional alpha and alpha that originates from absolute return products.
Traditional Alpha
This type of alpha is generated through traditional active management strategies (long-only positions in stocks and bonds) geared toward a specific market. The strategy consists of investing in a market where there is a high potential for added value and extracting any alpha that is generated by eliminating market exposure through futures or swaps.
The main advantages of traditional alpha sources include simplicity, transparency and accessibility.
Additionally, it is easier to find products with a long performance history, which tends to inspire investor confidence in the alpha source. However, one must be careful when analyzing historical performance since not all managers will be able to deliver sustainable value through traditional long-only mandates going forward—something that is crucial to the overall quality of the alpha source in the context of a portable alpha strategy. One has to be equally careful that the alpha is genuinely due to the manager’s abilities and not related to the beta.
Alpha Generated by Absolute Return Strategies
The other main sources of alpha are the so-called absolute return strategies. These investment vehicles are designed to deliver positive returns in all market conditions. Whether using tactical asset allocation, active currency management, long/short market neutral strategies with stocks or bonds, or multi-strategy hedge funds, all of these absolute return strategies are expected to outperform the return on Treasury Bills plus a certain premium, usually from anywhere between 3% and 5%.
Tactical asset allocation and active currency management are two macro strategies that both deal with the over- or underweighting of a market or currency based on short-term expectations. Both strategies are relatively straightforward and can be synthetically implemented by purchasing or selling a market index or a currency. This permits an active management of the beta (or broad market exposure) which, if properly executed, creates the possibility of additional added value. However, these two strategies tend to be highly volatile on their own and should therefore be used strategically with investors’ objectives or in combination with other strategies to allow for diversification.
Unlike tactical asset allocation and active currency management, multi-strategy hedge funds, and particularly funds of hedge funds, are well-diversified vehicles that generally come with low volatility and still offer good potential to generate alpha. However, funds of hedge funds come with their own set of drawbacks such as low liquidity, lack of transparency, complicated technical considerations and high fee structures.
With so many different strategies and managers, selecting the best alpha sources is crucial. However, choosing a quality alpha-generating product is not always straightforward. Unfortunately, many investors tend to look only at the historical performance of the strategy. As with all investment products, it is the risk-reward relationship that truly conveys the quality of the product. And it is this relationship that will allow one to quickly assess the quality of an alpha-generating vehicle.
Measuring Alpha
The risk-reward relationship is often quantified by the information ratio—the ratio of the added value to volatility. The information ratio is an appropriate measure to use when analyzing the performance of an alpha source. The target added value will, of course, vary depending on the strategy, but an information ratio in excess of 50% is often considered good. In this case, for every unit of risk, you would get a half a unit of return.
While the information ratio is an important measure, there are other considerations that must be taken into account before settling on an alpha source. First, one needs to ensure that the return being generated is genuine alpha and not the beta associated with an underlying strategy masquerading as alpha. Furthermore, the process used to generate alpha needs to be diverse, dependable and repeatable. As well, to maximize the benefit of the portable alpha strategy, it is important to minimize the correlation of the alpha source to the beta source and other asset classes. Lastly, liquidity, transparency and fee structure are all other important factors that need to be analyzed before choosing an alpha-generating product.
In short, there are a variety of different sources from which alpha can be extracted, each with its own advantages and drawbacks. What is important is to have well-defined objectives in seeking out an alpha source, and then choose the strategy that best fits those parameters.
Replicating Beta
Beta replication is another necessary factor when it comes to portable alpha. While less flashy and seemingly simpler than the alpha component, the ability to create the exposure to the desired market is crucial to ensuring a successful implementation of the portable alpha concept.
It is important that the beta exposure be achieved in a cost-effective fashion. It is also important to analyze and understand the different methods that can be used to synthetically create the desired beta exposure. Some investors like swaps, others like futures and still others opt for repurchase agreements.
Implementation Considerations
Generally speaking, there are two ways to go about implementing a portable alpha strategy:
1. Financial engineering carried out by the plan (in-house) and
2. Using a turnkey product.
The primary advantage of an in-house portable alpha strategy, once all the necessary resources are in place, is its enormous flexibility. Contrary to a turnkey product, on which both the alpha and beta sources are imposed, in-house financial engineering allows institutions to choose the alpha and beta sources that best suit their needs. However, this flexibility comes at a price, literally, as legal risks, counterparty risks and rebalancing between the beta and alpha must all be carried out by the sponsor, often at considerable time and expense.
In-house financial engineering is not for every pension plan. For those who do not have the necessary resources, turnkey products are offered by money managers where all these issues are internally managed by the fund. Nevertheless, the use of a turnkey product does not eliminate the necessity to carry out thorough due diligence. On the contrary, one still needs to know what the investment vehicle is and how good it is.
While still a relatively unused strategy, portable alpha is basically a process that uses existing products and packages them in a way that increases the opportunity set for the investor. While there are more moving parts than you would find in a more traditional mandate, portable alpha is nothing more than a different approach to portfolio construction, with a view to enhancing the risk-return profile of the total portfolio.
Brian White is vice-president and regional co-head with Aon Consulting. Etienne Dubé is a senior consultant with Aon Consulting. brian.white@aon.ca; etienne.dube@aon.ca
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