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The Evolution Of Portable Alpha
The vast majority of portable alpha approaches seek to outperform the equity market, and thus employ equity index futures or swaps to replicate the returns of the equity market on an ongoing basis. This is not surprising, as it was the introduction of S&P 500 index futures by the Chicago Mercantile Exchange in 1982 that paved the way for broad market “portable alpha” index enhancement. Specifically, the advent of the S&P 500 futures contract presented investors with the opportunity to maintain exposure to the equity market over the longer term at a short-term money market rate cost. For equity futures contracts, this cost is embedded in the price of the futures contracts and is usually very close to 3-month LIBOR, at least for highly liquid futures contracts. In the event that it drifts higher for some reason, arbitrageurs will typically step in, thereby pushing the financing rate back toward LIBOR. In the case of total return index swaps, the financing cost is specified as part of the contract, and also most commonly linked to short-term LIBOR rates.
The key to achieving higher returns than the reference beta or index lies in the performance of the alpha strategy relative to the money market cost of financing. It follows that portable alpha strategies may benefit from a “time horizon arbitrage” of sorts that is unique relative to most traditional actively managed strategies, due to the mismatch between the short-term money market cost of the beta exposure and the longer-term horizon of the investor. Rather than investing the capital retained solely in money market investments, investors can capitalize on their longer time horizon by investing in assets that bear some amount of additional risk in exchange for a higher expected return. This was the idea when Pimco launched its StocksPlus strategy shortly after the introduction of S&P 500 futures contracts more than two decades ago: Capitalize on long-term equity investor horizons by owning equity futures contracts collateralized by a portfolio of liquid, high-quality, short-term fixed-income assets that provide a modestly higher incremental yield and expected return above money market rates.
Over the years, investors have gravitated to portable alpha for multiple reasons. There is a certain appeal to the concept in that it reconciles the need for higher returns while still offering many of the same advantages of passive investing. It is commonly agreed that passive investing offers many significant advantages for investors across assets classes, including low costs, liquidity, capacity, diversification and ease of use. Portable alpha can offer many (in some cases, all) of these same benefits. It also is particularly compelling in segments of the market where it is difficult to identify traditional managers that produce consistently positive excess returns, such as the U.S. large-cap equity space. Portable alpha strategies avoid the risk of individual security selection by “owning the market” through derivatives, but expand the universe of strategies that can be employed to generate alpha relative to a given benchmark. In addition, there may be important improvements in the overall risk profile if there is a low and relatively stable correlation between the alpha strategy and the desired market (“beta”) exposure, as noted above, and also to the extent that the overall strategy provides excess returns that are uncorrelated with other actively managed strategies owned within an asset class.
Given all the potential benefits to investors and the increased interest on the part of investors, it is not surprising that a large number of variations of the portable alpha concept have been introduced by investment managers or undertaken by investors directly, as discussed toward the beginning of this article. A related reason for all of the interest and flows into portable alpha strategies is the substantial growth in the index derivative markets. Relative to even as recently as five years ago, the number of available futures contracts is much broader, now including international and emerging markets equity contracts as examples. At the same time, the over-the-counter (swap) markets became substantially more liquid and active. Movement toward standardized over-the-counter contractual arrangements has also improved the willingness of investors to establish such exposures.
It’s important to remember, however, that no strategy is without risks and pitfalls. Over the past few years, we’ve seen that portable alpha is not immune to the return-hungry, risk-agnostic attitude that permeated some parts of the marketplace. The downside of excessive leverage and poor risk evaluation and measurement ultimately contributed to the broad-based market dislocations and de-leveraging we’ve seen recently. Various portable alpha strategies were marketed without any mention of the downside risk of the alpha component—the beta component was assumed to have risk, while alpha strategies that promised returns of 4 percent over LIBOR or more (after accounting for very high fees) in some cases were essentially put forth as being risk-less to the end investor, such that investors may have been led to believe that their downside was limited to that of the beta component alone. In addition, often there was very little mention or consideration of the liquidity that is absolutely critical to the ability to maintain the derivatives market exposure during volatile and downward-trending market environments, among other key aspects of portable alpha that may have been glossed over. From our perspective, this was quite concerning—and rightly so, as it turns out—which is why we actually felt compelled to write the book “Portable Alpha Theory and Practice: What Investors Really Need to Know,” turning in our first draft to the publisher well before August 2007. Our colleague Chris Dialynas put it best in the epilogue:
“Ironically, what began in the early 1980’s as a simple finance arbitrage Pimco portable alpha strategy has evolved in some cases to highly leveraged, unregulated portable alpha hedge fund strategies. Both are referred to as the alpha source in a portable alpha context, but they are vastly different in terms of the potential downside risk.”
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