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These same challenges are likely to present themselves when the derivatives-based beta exposure is an equity index. In addition, the actual and potential volatility and downside risk of the equity market is very relevant when considering the appropriate level of liquidity in the collateral alpha strategy—as many who executed portable alpha strategies during the relatively benign low-volatility and positive equity market return period from 2003 to mid-2007 can certainly now attest.
In Figure 4, note the differences between the passive S&P 500 Index performance in 2008, and over the last 10 years, relative to a hypothetical portable alpha strategy. As before, the hypothetical returns assume that the collateral portfolio is invested in the HFRI Fund-Weighted Composite Index and the passive index derivative return is approximated by the return of the S&P 500 minus 3-month LIBOR. Over the 10-year period, the strategy generated very attractive excess return. However, most striking from a risk standpoint is that this combination results in an equity beta coefficient that is nearly 40 percent higher than the index.
Is this still an equity strategy with a risk profile that is similar to the S&P 500? The answer to that question for most is probably a resounding “no.” As an interesting point of comparison, the 10-year historical beta of this strategy is higher than that of any traditional active equity manager universe over this time period.1
We offer these examples not to disparage the concept of using hedge fund strategies as the collateral alpha strategy investment, but rather to illustrate how different portable alpha approaches can have risk-and-return profiles that differ, perhaps meaningfully, from the referenced passive market index. Successful portable alpha implementation over the long term is contingent on appropriate risk management and measurement—which, in turn, requires an appropriate level of transparency. Again, we believe an understanding of the potentially higher downside risk of such a strategy is important at the individual investment, asset class and overall plan levels.
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