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If it’s worth doing in the pension world, it’s worth doing slowly. This guidance has served pension plan sponsors well. Assets represent the security of all plan participants’ retirement income, and new investment opportunities should be, and need to be, carefully considered. Many have taken this counsel when it comes to evaluating the merits of portable alpha, a strategy that has been successfully applied for many years by larger pension plans and is gaining popularity among the broader pension investment community. However, as plan sponsors have worked through the education process and gained comfort with the risk/return profile of portable alpha strategies, some have found implementation and ongoing issues, such as documentation, custody and reporting/accounting, to be barriers to making the first investment. A pooled, or “turn-key,” offering is a compelling option because this approach significantly reduces the operational and reporting challenges presented by portable alpha structures.
ALPHA AND BETA
Generally, a portable alpha mandate involves the combination of a derivative instrument(for example, a future or swap) to secure a particular market exposure, the beta, and an investment in an actively managed strategy, the alpha. By employing such an approach, alpha and beta decisions are separated, thereby increasing the opportunity set within which an investor can look for attractive, consistent manager skill. The benefits are compelling; for example, some strategies can offer meaningful excess return opportunity from a longer-term bond portfolio, that is, alpha in the range of 1.5% to 3.5% net of fees, while adding little incremental risk. Furthermore, with a turn-key product, all required documentation(for example, ISDA agreements and trade confirmations)and liquidity management are addressed by the manager of the product. This approach also offers ease of accounting, reporting and performance attribution since the investment appears as a single line item on the pension portfolio’s custodial statement.
With these benefits, however, come a number of considerations when evaluating a turn-key product. First, a turn-key approach will somewhat limit the flexibility afforded larger investors as the active risk target and market exposures are defined by the manager of the pooled offering. For example, a bond-based portable alpha product may be benchmarked to a conventional fixed income index, whereas an investor may prefer specific interest rate exposure to better match their liabilities. Second, a turn-key approach can be less transparent with respect to costs. Two main costs include(i)the cost of securing the market exposure and(ii)the cost of liquidity management, including the opportunity cost of holding liquid money market instruments versus alpha-generating investments and the fee for instituting some form of credit facility to support cash settlements. Accordingly, the provider of the turn-key product should have demonstrated experience in derivative management, both futures management to mitigate tracking error as well as capabilities in implementing swaps to secure best pricing and negotiate appropriate terms such as credit mitigation clauses and posting of collateral.
Portable alpha strategies have been utilized by some of the largest and most well-known institutional investors for more than 20 years with increased interest from smaller plans developing more recently. This complements the overall trends in the pension investment community of employing more derivative-based portfolio solutions to manage overall plan risk through liability-driven solutions, improving returns in an alpha-beta separation framework or a combination of the two. A turn-key portable alpha product is an attractive way for an investor to experience the benefits of this strategy and also to gain comfort with the mandate’s reporting and operational aspects. Yet while a turn-key approach can open the door to increased return opportunity from active management, investors also need to look closely inside to ensure that this hard work is not being paid away by costly implementation or ineffective management of the overall structure.
Stephen Foote is vice-president with Northwater Capital in Toronto. sfoote@northwatercapital.com
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