Portable Alpha

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Portable Alpha
Chris BriseboisApril 4, 2006
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Table of contents 

• The shift in investment paradigm
• Portable alpha, portable beta and their roles
• Pension fund experience with porting strategies
• Implementation issues
• Governance issues
• Conclusions

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The shift in investment paradigm The traditional
approach

• A two stage process policy and implementation
• Determine the strategic asset allocation (SAA)
• Identify the policy benchmark
• Create manager mandates from the benchmarks
• Hire managers to add value over the benchmarks

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The shift contdWhats wrong?

• Pension fund risk and return are dominated by
  markets manager contribution is minimal
• Funds aren't compensated appropriately for risk
  taken
• Periods of low or negative returns create funding
  problems
• Benchmarks typically include a number of
  duration, inflation and currency exposures that
  are not expected to be rewarded
• Extreme concentration on benchmarks and limited
  breadth of manager skill
• Alpha and beta are not well balanced

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The shift (cont'd)An alternative approach

• Separate liability management from asset
  management
• Separate alpha and beta
• Overlay liability matching portfolio with an
  absolute return portfolio
• Construct absolute return portfolio by porting
  alpha and beta

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Portable alpha, portable beta and their roles 

• What is portable alpha?
• The removal of market exposure to isolate manager
  skill
• Importance of portable beta
• Whenever manager skill opportunities are
  attractive but the asset class is not

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Portable alpha contd

• What is portable beta?
• The addition of pure beta to an absolute return
  portfolio so alpha and beta can compete side by
  side

• Why?
• Some betas provide positive expected returns
  (compared to alphas which are generated at
  another's expense)
• Betas increase investing capacity
• Betas can provide additional opportunity for
  alpha breadth (e.g. TAA)

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Portable alpha (cont'd)
 BENEFITS
 CHALLENGES

• Duration, inflation and currency exposures can be
  managed more precisely
• More breadth
• The balance between alpha and beta drivers is
  explicit

• Implementation
• Governance
• Costs  

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Portable alpha (cont'd)
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Pension Fund experience with porting strategies 

• U.S.
• JP Morgan May 2005 study of 125 largest DB plans
  ("New Sources of Return Survey")
• 28 have used portable alpha strategies, both
  outsourced and constructed internally
• 36 are considering using these strategies
• Surprisingly
• 7 aren't familiar with the term "portable alpha"
• 45 aren't using derivatives
• Only 36 use leverage through debt-financed real
  estate or to gain notional market exposure
  through derivatives

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Pension Fund experience contd

• Canada
• Minimal use to date, the most being outsourced
  product for enhanced index returns
• Hedge funds, representing a particular type of
  portable alpha (whether standalone or in an
  overlay), represents just over 5 of total
  investments (1)

(1) The 2005-2006 Russell Survey on Alternative
Investing
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Pension Fund experience (cont'd)

• Watson Wyatt Experience
• Replacement of traditional ALM studies with risk
  budgeting which does not limit decisions to the
  old paradigm
• Portable alpha assignments conducted around the
  world (except Hong Kong) with the most in the UK
  (29 in 2004)
• Canadian portable alpha work
• Longest mandate has a four year history long
  bond beta portfolio and a market neutral fund of
  hedge funds
• To date hedge funds have been used as the alpha
  source but exploring new alphas such as
  "diversity portfolios
• Allocations have started at 5 but moving
  towards 25

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Pension Fund experience (cont'd)

• Examples of porting alpha and beta
• Alpha from an area where manager skill can make a
  difference (e.g. small cap, global bonds, hedge
  funds)
• Beta from a market that has a positive expected
  return and can provide capacity (e.g. domestic
  bonds, US large cap)
• Examples
• Universe bond beta with a global bond alpha
• SP500 beta with US small cap alpha
• Any futures strategy backed by hedge funds
  instead of cash

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Implementation issues

• Matching portfolio
• Estimates for matching
• Method for matching (e.g. cash flows)
• Degree of matching
• Time horizon of the match (typically 30 years)

• Absolute return portfolio
• Identifying a wide range of alpha sources
• Ensuring diversification when alpha returns and
  correlations are difficult to estimate and
  stability is low
• Fee levels eroding the return potential

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Implementation issues (cont'd)Practical issues
with the absolute return portfolio

• Pooled funds make implementation easier but have
  more governance issues
• Managing derivative and leverage exposures
• Special risks such as illiquidity, counterparty,
  capacity and erosion of alpha
• Skill level for selecting and monitoring
  synthetic instruments
• Ability of custodian to handle new instruments
  and strategies
• Hedging out unwanted beta exposure may not be
  possible
• Setting the right time horizon and expectations
  for success (i.e. alpha doesn't always perform)

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Governance issues 

• New skill set for all fiduciary groups
• Monitoring and evaluating indirect investments
  through swaps and other derivative arrangements
• Evaluating performance relative to liabilities
• New mindset
• Positions on transparency, leverage and where the
  
• Managing the pension fund as a special type of
  hedge fund
• Changing the degree of delegation and respective
  duties of different groups
• Changing policy guidelines!

PRACTICAL GOVERNANCE STRUCTURES ARE WELL SUITED
TO THE CURRENT INVESTMENT PARADIGM BUT ARE AN
IMPEDIMENT TO AN ALTERNATIVE APPROACH
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Conclusions

• The alternative approach to managing investments
  through portable alpha and beta is better than
  the traditional approach BUT the governance
  issues are considerable
• This approach is becoming increasingly popular as
  evidenced through transitional activities of more
  matching portfolios (still mostly just longer
  bonds) and portable alpha in return enhancement
  strategies
• Huge opportunity , and challenge, for investment
  managers and pension fund fiduciaries
• Governance budget will become important as part
  of the change

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Questions for the audience 

• Is portable alpha only a theoretical concept?
• Is alpha really just beta that we've yet to
  identify?
• Is it easier to predict manager skill than it is
  to predict market returns?
• Do we have the right governance structure to
  shift paradigms?
• Going forward, how do we ensure governance
  structures will accommodate evolving requirements?

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Questions