Portable alpha fails to deliver the goods

Some institutional investors are ending their portable alpha programs and others are scaling back as a painful year in the markets winds down.

However, while conceding widespread disappointment in 2008, proponents say a focus on better matching those programs' beta and alpha segments will pave the way for renewed interest in the strategy in 2009.

For now, investors are still reeling from the capital market fallout that followed the bankruptcy of Lehman Brothers Holdings Inc. on Sept. 15. With the beta side of those portable alpha programs crushed by the precipitous decline of equity markets, and the alpha side — largely hedge funds of funds — suffering unexpectedly steep losses, some investors have walked away.

The chief investment officer of one large U.S. corporate defined benefit plan, who declined to be named, said his company “abandoned” its portable alpha program after a brief trial. Staff concluded that “it wasn't profitable for us,” he said.

Others — including the Pennsylvania State Employees Retirement System, Harrisburg, and the South Carolina Retirement Systems, Columbus — have reduced the beta side of their programs, at least for now, to guard against having to find cash to top up swaps or futures positions should the market continue to fall.

Amid the market turmoil, PennSERS is taking a tactical approach to portable alpha, reducing its beta exposure to less than $2 billion (from a peak of $8.6 billion in early 2007) by not renewing expiring swaps contracts, said Robert Gentzel, a spokesman for the $31.2 billion system.

PennSERS adjusted the alpha side of its program last year by moving $3.3 billion of its portable alpha hedge fund-of-funds exposure to its absolute-return allocation. As of Sept. 30, there was still $5.24 billion in hedge funds of funds related to the portable alpha program, with less than half that amount in beta exposure. PennSERS officials are assessing what they will do with the program when calm returns to the capital markets, Mr. Gentzel said.

Beta overlay cutback

Robert L. Borden, CIO of the South Carolina pension fund, said officials there cut back the beta overlay portion of the portable alpha program from 20% of its $20 billion portfolio to between 10% and 15% to “take volatility off the table.”

“We can step back in at any time if we think market conditions have stabilized,” Mr. Borden said. South Carolina managers the beta and alpha portions of its program separately.

Other investors have tweaked both sides of their programs. On Dec. 19, the $7.3 billion San Diego County Employees Retirement Association announced it would trim the alpha and beta portions of its portable alpha program to 14% of its portfolio from 19%.

Several of its hedge funds managers “will be reallocated to other asset allocation buckets and the remaining hedge fund managers in the Alpha Engine will be proportionately drawn down,” Brian White, chief executive officer, wrote in an e-mail.

If the prospect of having to come up with cash to meet daily margin calls has proved a nightmare in an illiquid market, declines of 10% or more this year for the hedge funds of funds used as the “alpha engine” in a number of portable alpha programs have been an added disappointment, observers said.

In theory, at least, the goal of putting money in so-called “absolute-return” strategies was to provide a consistent, positive return in down markets as well as up, but they've failed to do that, said Mr. Gentzel.

Mr. White said over his staff will be analyzing the unexpected and “unprecedented high correlation” exhibited between his program's alpha strategies and its S&P 500 exposure to determine whether “this is a fundamental shift or a short term aberration.”

Michael Travaglini, executive director of the $39.6 billion Massachusetts Pension Reserves Investment Management Board, Boston, said the 15% decline suffered by PRIM's hedge-fund-of-funds providers was well below expectations.

Still, Mr. Travaglini said PRIM officials remain convinced that their portable alpha program, at 6% of its overall portfolio, will add value over time. The market's current implosion is a poor time to be making judgments on the long-term merits of the strategy, he added.

"Poor, or poorer"

With the types of hedge funds widely used in portable alpha programs down 15% or more through Nov. 30, portable alpha programs have performed “as poor, or poorer, than anyone could have expected.” said Richard Charlton, chairman of NEPC LLC, Cambridge, Mass., a leading proponent of portable alpha. But over three-, five- and 10-year periods, he said, they are continuing to deliver better returns than either bonds or stocks, with a fraction of the volatility.

Mr. Charlton predicted that clients who established programs during the past 12 to 15 months might waver, but anyone who got in three years ago or more will conclude that they're still well ahead of where they would have been if they had opted for a more traditional lineup of long-only exposure to stocks and bonds.

The strategy covers “a very broad spectrum of alpha engines,” and the key is choosing sources of alpha complementary to the beta exposure, as opposed to ending up with “undesired beta leverage,” noted Sabrina Callin, an executive vice president with Newport Beach, Calif.-based Pacific Investment Management Co., and author of a book on portable alpha.

The director of trust investments with another large corporate defined benefit plan, who declined to be named, agreed, saying the more severe damage being reported by portable alpha programs this year reflects “problems with implementation,” not problems with the strategy itself.

Rather than finding truly diversified, uncorrelated sources of alpha, too many of the programs that fall under the rubric of “portable alpha” have been using hedge fund programs with excessive beta exposure, and the real problem came when those programs delivered “two times the beta of the market” in a plunging market, the corporate pension executive said.

Alan van Noord, chief investment officer of the Harrisburg-based Pennsylvania Public School Employees’ Retirement System, whose $55 billion portfolio has a roughly 8% allocation to the strategy, said PSERS has benefited from structuring its program carefully to avoid “managers that have a lot of market beta,” and maintain sufficient liquidity to cover the daily cash adjustments on the S&P 500 futures contracts it uses for the program's beta exposure.

Direct approach

To maintain more control and oversight than hedge funds of funds would have allowed, PSERS invested directly in institutional quality hedge funds for its alpha engine, while managing the beta portion of the program in-house.

Entering 2008, officials said strategies using short-duration fixed income for their alpha engine, such as PIMCO's StocksPlus, accounted for roughly half of PSERS portable alpha program, although that total has been trimmed during the year. Managers of global macro, equity long/short, currency overlay, emerging market debt and option overlays strategies account for the rest.

Through Sept. 30, the alpha side of PSERS' program had suffered a 5.6% decline. PSERS officials declined to provide more recent data, but said they haven't had to cut back their portable alpha exposure, which remains a tool to meet an annual 8.5% return target in an unforgiving market environment.

In retrospect, this year will stand as a “stress test” for portable alpha, providing guidelines for “how much cash” may be needed amid unprecedented market volatility, Mr. Van Noord said. “We've been through that process, seen what the worst can bring, and been able to work through it,” he said.

Despite the disappointments of the year, some market veterans predict portable alpha will deliver strong returns during the coming year. “Portable alpha is getting a nasty black eye in 2008, but that doesn't mean it's not a sound strategy when it's properly implemented,” said Robert D. Arnott, chief executive officer of Pasadena, Calif.-based Research Affiliates LLC. Especially for alpha strategies focused on segments of the bond market that have been crushed this year, 2009 might well be “an extraordinary year,” he predicted.

South Carolina's Mr. Borden said he'll be watching the tug of war between the economy tumbling into recession and a government working hard to come up with stimulus measures to reverse the decline.

“When we feel we're at an inflexion point, we'll consider putting beta exposure back on,” he said. And while results on the alpha side of SCRS's program have been disappointing, Mr. Borden said along with the pain that market mayhem is creating now, comes “vast amounts of opportunity for alpha generation.”