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Alpha And Beta: It’s the Combination That Matters, As Does The Execution
This is not to say that all portable alpha strategies that involve the use of hedge funds as the alpha strategy are bad or highly risky. There are surely any number of successful, prudent approaches that involve hedge funds. Regardless of the approach, though, as a starting point, proper quantification of investment and operational risk in portable alpha programs is a necessary ingredient to well-informed investment, benchmarking, risk budgeting and asset allocation efforts. Risk management and measurement is a crucial component of a successful portable alpha strategy.
While portable alpha may seem to be an elegant and low-risk way to earn excess returns in addition to the return from the reference market index, there really is no such thing as a free lunch in the financial markets. The fundamental laws of investing apply to portable alpha just as they do to any other type of investment. It is almost always necessary to take some type of risk in order to generate return over money market rates. While portable alpha strategies may seem simple in theory, they cannot outperform the reference index 100 percent of the time. The primary risks of portable alpha strategies in this regard can include: (1) the potential for under-performance in the collateral (alpha) portfolio, (2) a spike in the financing costs for futures/swaps, (3) margin calls on the derivatives in a falling market, which force the liquidation of the most liquid (and highest-quality) parts of the portfolio, or (4) operational errors.
Investors should carefully evaluate both the risk of the derivatives-based index exposure and the alpha strategy when attempting to understand the overall risk of the strategy. Focusing first on the alpha side of the equation, investors should understand the liquidity of the portfolio. Futures margin is typically settled on a next-day basis, and swap collateral requirements may be settled as frequently as daily in stressed market environments. Consequently, understanding portfolio liquidity is critically important. Similarly, understanding the alpha portfolio’s expected behavior during periods of market stress may provide insight into how the portfolio as a whole behaves in down markets. Well-informed analysis will focus on the sources of return in the alpha portfolio and the risk factor exposures that drive those returns. Further analysis should focus on the likely correlation of those risk factors across different market environments and to what extent the risks are identifiable, measurable and can be diversified.
For instance, combining a derivatives-based fixed-income index exposure with a hedge fund alpha strategy may result in a strategy with a very different risk profile than the passive fixed-income index. This can be problematic because the passive fixed-income index presumably serves as the benchmark for the overall strategy and also serves as the proxy for the strategy in the investor’s asset allocation. An illustrative example is shown in Figure 3.
The analysis in Figure 3 compares a hypothetical investment in a portable alpha strategy where the collateral portfolio is invested in the HFRI Fund-Weighted Composite Index (the HFRI composite index provides an equal-weighted average return of over 2,000 hedge funds). The derivatives-based beta or index returns are approximated by the return of the Barclays Aggregate Bond Index minus 3-month LIBOR.
How satisfied would an investor have been with this investment in 2008? Based on a cursory review of the data in Figure 3, it is challenging to have much to say on the positive front in light of:
• A negative excess return of 22.4 percent and negative absolute return of 17.2 percent (the bond index returned a positive 5.2 percent)
• Over two times the volatility of the passive bond index
But had you been invested in the strategy for the last 10 years, how satisfied would you be? Even with 2008’s challenges, the strategy referenced in this example produced a very healthy excess return of 3.6 percent (excluding any overlay costs, other costs and fees and “slippage” related to imperfect alignment between the value of the underlying hedge fund investment and the bond overlay). Very nice to have the extra returns for sure, but is this really a bond investment? Look closely at the risk statistics. The strategy exhibited more than double the volatility of bonds and was more correlated (61 percent) with the S&P 500 than with the Barclays Aggregate (46 percent). So not only might it be debatable as to how to classify this investment, it may be challenging to properly benchmark the strategy. Based on the historical performance characteristics of the strategy, can one really assume that it will behave in a similar manner as the passive bond index? Return and especially risk assumptions should be ratcheted up for any plan-level risk budgeting and asset allocation efforts.
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