Another potential advantage to this approach is that the investor can periodically change the level of equity exposure to accommodate plan-level asset allocation and rebalancing adjustments. When equity and fixed income markets move in opposite directions or in different magnitudes, plan sponsors need to periodically rebalance the asset mix toward the policy target. In a typical mandate, this usually means selling and buying physical securities, which generates transaction costs. A long-duration portable alpha portfolio may provide some cost savings, as rebalancing does not require disruption of the underlying fixed income portfolio. Buying and selling futures also tends to be more cost-effective than trading a portfolio of stocks.
Figure 1: Empirical duration of the TSX-Fluctuations from 1982 to 2009
Risk management
Additionally, such an approach may offer downside risk management benefits relative to passive and active equity strategies. Historically, high-quality long-duration fixed income portfolios have exhibited a strong negative correlation with equities during weak equity market environments, when many investors typically embark on a “flight to quality” toward high-quality fixed income instruments.
A long-duration portable alpha approach, therefore, has the potential to deliver strong excess returns during weak equity markets. There may also be a potential benefit of diversification of equity market excess returns for investors with allocations to both the long-duration portable alpha strategy and traditional active equity strategies.
The most common source of potential outperformance in a typical equity mandate is stock selection. Active equity managers use many techniques to help build and maintain a stock portfolio that seeks to deliver a total return that exceeds the total return of the associated equity index benchmark. However, the manager must pick the right stocks—period after period, in all market environments—in addition to overcoming what can be high transaction costs for certain strategies.
By comparison, the alpha source in a long-duration portable alpha strategy is based on fixed income. The ability to generate excess returns is a function of the ability to produce potential returns on the fixed income portfolio that is higher than the money market interest rate cost associated with equity index derivatives. Because money market instruments are generally the lowest-yielding in the fixed income universe, a long-duration portfolio has the potential to generate an attractive positive incremental yield premium and associated excess return relative to money markets—and, therefore, the equity market index—over time.
Pension committee considerations
Before implementing a long-duration portable alpha strategy, there are a number of complications that plan sponsors need to consider. It’s important to recognize that derivatives-based equity beta management is neither easy nor straightforward. Combining two relatively volatile asset classes—equities and long-duration bonds—requires routine realignment of the equity exposure as the underlying fixed income asset values change. Similarly, the appreciation or depreciation of the equity market will result in margin payments, requiring the investment of cash or the sale of bonds to raise cash.
Given the strategy’s higher level of portfolio volatility than a stand-alone long-duration portfolio, it is critical to closely monitor the fixed income risk exposures relative to desired levels. A long-duration portable alpha strategy typically benefits from efficient synthetic exposure to various equity indexes and the opportunity to obtain the most attractively priced financing when rolling futures contracts from one expiration to the next.
Liquidity management is another important aspect. Robust margin and collateral management procedures are needed to help facilitate equity exposure management in various market environments. Even in the absence of a substantial decline in equity values, active cash flow management is one of the key factors behind optimal implementation of this strategy. By withdrawing excess margin flow daily to ensure that only the minimum required amount is maintained on deposit with clearing members, the portfolio manager can properly invest margin proceeds that are consistent with current market opportunities. Likewise, when margin payments are required, the portfolio manager must be prepared to readily meet those payments and make restructuring decisions at the appropriate time in an effort to create additional liquidity.
To ensure that all of these challenges are handled appropriately, pension plan sponsors should look for experienced investment managers with established processes. For pension plans and other equity investors with long-term liabilities, a long-duration portable alpha strategy may provide attractive additional return benefits, both absolute and relative to liabilities, compared with traditional equity mandates.
Stuart Graham is president of PIMCO Canada Corp. and Steve Jones is vice-president and product manager for PIMCO’s derivatives-based and active equity strategies.
stuart.graham@pimco.com
steve.jones@pimco.com
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© Copyright 2010 Rogers Publishing Ltd. This article first appeared in the March 2010 edition of BENEFITS CANADA magazine.
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