The Future Of Portable Alpha

June 22, 2009

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Portable alpha approaches—which essentially involve seeking beta from one asset class and alpha from another—have fallen under a cloud, as have many other investment strategies, in the wake of the recent market turmoil. However, they can yield potentially powerful results for investors both in terms of risk-adjusted excess return and diversification benefits, which explains, at least in part, the heightened interest in portable alpha following the equity market sell-off in 2000–2002. Traditional stock and bond investment return expectations were relatively low, and investors were concerned about meeting return targets that were in many cases in the 7–10 percent range. As a result, investors as a group were more open to new investment categories and approaches, including those that employ the use of derivatives and leverage, like portable alpha.

At the time, portable alpha and related concepts were touted as a new paradigm in investment management, and even the holy grail of investing. The variety of different approaches to porting alpha and the number of providers of related products ballooned, as did the conferences dedicated to the topic. Generally speaking, investors seemed happy with the results. Of course, most of the newer approaches to portable alpha were implemented in the low- and declining-volatility environment that ended in 2007, with risk premiums initially rising to levels closer to historical averages before spiking to new highs this past fall.

Unfortunately for some investors, successful portable alpha implementation has proven to be much more complicated in practice than it may sound in theory. Portable-alpha-related losses experienced by some have been highlighted in the public domain, likely causing some investors to question the merit of the entire concept.

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What does the future hold for portable alpha? The fundamental concepts that provide the basis for the viability and benefits of portable alpha for long-term investors are very much alive and well. There have been important lessons learned, though. As a result, we are likely to see a bifurcation of the marketplace where portable alpha approaches that share certain important characteristics are likely to survive and even thrive, while others may disappear. In particular, we believe approaches that capitalize on the attractive risk premiums available in the high-quality, relatively liquid fixed-income arena merit serious consideration by investors.

Portable Alpha, Defined

Not surprisingly given the wide variety of approaches employed, the definitions of the term “portable alpha” vary depending on who you ask. So far as we are aware, though, all strategies that fall under the portable alpha umbrella involve the use of derivatives (or a similar borrowing arrangement) to obtain the desired asset class or market index exposure, typically referred to as “beta,” thereby allowing risk-adjusted excess returns or “alpha” to be sourced from an entirely distinct asset class or active management strategy. Central to the idea and also the potential value of portable alpha are the concepts of borrowing to achieve higher returns, and diversification as a means to increase the return per unit of risk. Sound familiar? These are also two of the key concepts that underlie modern portfolio theory as introduced in the middle of the 20th century and detailed in every investment textbook.

The potential diversification benefit is derived from the fact that an investor’s capital may be invested in assets that are independent from—and complementary to—the derivatives-based beta exposure. Let’s say that an investor has $1. They can buy $1 of the desired index exposure for just a few pennies using derivatives, and have the rest of the $1 to place in an entirely separate and distinct investment. Simplistically speaking, the combined return will be equal to the total return of the index (beta) minus the associated financing rate (as explained below) plus the total return of the collateral or alpha strategy. The returns from the two components are additive, while the risk is not entirely additive—as it would be if the two were perfectly correlated.

It is difficult to predict future correlations: Assets that historically have not been correlated or have had relatively low correlations during periods of low volatility may turn out to have very high correlations during periods of market stress. Nonetheless, so long as the risk factor exposure in the alpha strategy is transparent, investors should be able to determine whether or not a material, positive diversification benefit should exist over the long term. One example of this may be the combination of equity derivatives and a carefully risk-controlled, high-quality, fixed-income alpha strategy portfolio. Of note is the fact that the Barclays Capital U.S. Aggregate Bond Index had a positive return of 5.2 percent in 2008. Historically, this index has had a negative correlation with equities during periods of equity market stress, which logically makes sense due to the flight-to-quality impact.

The borrowing component of portable alpha approaches is typically accomplished using index futures or swaps that are designed to provide the total return of the associated market index, less a financing rate, as noted above. The financing rate associated with index ownership using derivatives is consistent with other “buy now, pay later” forms of asset ownership—financing an appliance, a car or a house, for example. The important question from the standpoint of prospective investors in a portable alpha strategy is: Are there readily available, liquid, cost-effective derivatives available to replicate my desired index or beta exposure? In the case of certain indexes or market exposures, the financing cost may be compelling for long-term investors, while in others, the cost may be significantly higher if the exposure is even available synthetically.

 

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