Investors learned a painful lesson on portable alpha during the financial crisis. Why they're now taking a second look.

Hedge fund investors are increasingly paying attention to a strategy that hit its zenith of popularity and assets nearly two decades ago before being badly battered during the global financial crisis: portable alpha.

Portable alpha, also sometimes called capital efficiency, beta overlay or return stacking, is back and in vogue. The strategy gives investors exposure to an index through derivatives, such as the S&P 500 or Bloomberg Aggregate Bond index, and then that performance beta is coupled with an alternative stream of alpha, such as hedge funds, which offer a variety of different investment strategies. The combined aim is to enhance the underlying return of the beta exposure and ultimately beat the beta return.

Some institutional investors have used portable alpha for decades, but it is now again being increasingly discussed, said Chris Walvoord, an independent consultant who was formerly the global head of liquid alternatives research and portfolio management at Aon.

“I think it’s back because, first off, people are, I think, slowly but surely coming around (to the idea) that for a lot of betas, it’s hard to add much alpha. For U.S. large-cap stocks, it’s really hard to add value. And so, if you want to beat an index, you probably have to get more creative and portable alpha is one way to do it,” he said.

Another reason Walvoord points to is as investors look for other sources of alpha outside of equities and bonds, some decide they don’t want a pure hedge fund allocation or need to bucket the strategy within an existing area that matches the overlay.

“But if I can put it in some sort of portable alpha format, then I get some of those other sources of alpha, quote unquote, but it fits into my portfolio, my top-down portfolio structure more neatly,” he said.

Only 12% of allocators currently have a portable alpha program, but 21% are considering it, according to Goldman Sachs’ February prime services hedge fund outlook report, which surveyed 358 allocator firms globally. Sixty-seven percent said they were not looking at portable alpha and have no plans to do so.

The Goldman survey found that for those with existing portable alpha strategies, half implement it themselves — investing in hedge funds and then sourcing beta separately — while the other half utilizes packaged solutions hedge fund managers offer. Portable alpha does remain the domain of large investors, with over 40% of investors with at least $5 billion in hedge fund investments using a portable alpha construct, according to the survey.

Goldman Sachs believes many allocators are looking to beta-1 products, which encompass long-only, portable alpha and active extension products, because of “the ongoing struggles of active long-only managers to generate outperformance, exacerbated by narrow market breadth in recent years.”

Barclays’ January prime services capital solutions hedge fund outlook report that surveyed 325 investors had similar findings, with approximately 25% of allocators reporting they have portable alpha in their portfolios and the majority of those using equity indexes for beta and multistrategy or equity hedge funds for the alpha component. The survey found the average management and performance fees for the alpha side of portable alpha programs were 1.4% and 17.4%, respectively.

But Barclays found an even smaller number — less than 5% — of investors who are not allocated to portable alpha and are looking to invest for the first time.

And some of the resistance could be due to the experience investors had in 2007-2008 when assumed correlations between alphas and the beta collapsed, sources said.

Blast from the past

Portable alpha traces its roots back to the 1980s, with PIMCO launched its first portable alpha strategy in 1986.

“Portable alpha strategies are neither a new concept nor exclusive to PIMCO. Their popularity has ebbed and flowed over the last 40 years,” a spokesperson for the firm said in an email. “We believe a carefully constructed and risk-managed portable alpha program can add value to investor portfolios.”

PIMCO manages $31 billion, as of Dec. 31, in its traditional portable alpha solutions StockPLUS suite of funds and strategies that combine exposure to equity market indexes via futures or swaps with active fixed-income alpha strategies.

And PIMCO also offers hedge fund portable alpha solutions with $3 billion in custom mandates that use its hedge funds as of Feb. 28, the spokesperson said, adding that the firm has seen a “significant pickup in engagement in this space,” with investors using hedge funds as alpha sources paired with equities, fixed income, commodities or multiasset-class exposure. “In a few unique cases, we have implemented the hedge fund alpha strategy as the overlay on a fixed-income portfolio,” the spokesperson said.

Portable alpha was a popular institutional strategy in the run-up to the great financial crisis of 2007-2008. P&I survey data of the top 200 U.S. retirement plans showed a peak of $50.3 billion of assets in portable alpha as of Sept. 30, 2007. A year later, that figure had fallen to $41 billion and by 2009 it was down to $23.2 billion. Twelve years ago, P&I dropped portable alpha as a category from its plan sponsor survey.

Several large pension funds that had billions invested in portable alpha in 2007-2008, including the $38.7 billion Pennsylvania State Employees' Retirement System, Harrisburg; the $79.5 billion Pennsylvania Public School Employees' Retirement, Harrisburg; and the $109.7 billion Massachusetts Pension Reserves Investment Management Board, Boston, all told P&I that they are no longer using the strategy.

Alan Biller, founder and chairman of consultant and OCIO firm Alan Biller and Associates, has been running a portable alpha strategy with convertible arbitrage as the overlay for one client since the early 1990s and he said it has done well.

During 2007-2008, Biller was an investment consultant working with the Seattle-based Western Conference of Teamsters' Pension Trust's $3.1 billion portable alpha program. The program used alpha from an unleveraged convertible arbitrage hedge fund on its domestic portion and a global long/short tactical asset allocation strategy on its international portion and both strategies rebounded in 2009.

The crisis brought lessons, Biller said. “What we learned in 2008, of course, was that overlay strategies can blow up along with other things, and that the strategy we were relying on, convertible arbitrage, for many managers, many firms blew up because they were highly leveraged … so we became increasingly sensitive to the risks of overlay strategies themselves.”

Since then, they’ve looked at strategies that are not highly levered with liquidity that “is not likely to simply evaporate,” he said, adding that it’s “the pot of gold … which is a reliable strategy which will produce small, consistent excess returns and will not blow up on us.”

Biller said they use currency overlay and convertible arbitrage, but notes that it is a minority of clients that have portable alpha programs, and it can be challenging to explain how the strategies work to multiemployer plans with boards when it will only be a very small portion of a portfolio. But there has been a slight uptick in interest, he added.

Biller's thoughts on why portable alpha is back: “All I can think of is a dearth of new ideas, and so people are recycling old ones,” Biller said with a laugh. “I don't have a better explanation. I'd like to say there's something in the Gestalt, there’s something in the markets … But I actually think it's more that people are not coming up with really anything novel or sort of recycling things which had their heyday. Perhaps it's a new generation who don't remember that some of these strategies had their heyday and didn't work.”

Texas Teachers' portable alpha program

The $211.6 billion Teacher Retirement System of Texas has approximately $12 billion in its portable alpha program, which launched in 2019 (the system did not have a portable alpha program back in 2007-2008), said Lulu Llano, head of stable value hedge funds. The program sits within the public equities portfolio and competes for the same capital as long-only equity strategies, she added.

“What we’re doing within that program is taking that group of hedge funds and equitizing the beta to take them to beta-1 so we can compare them with the long-only funds and our policy benchmarks. So that's how we use our portable alpha program,” she said.

The program came about because hedge funds were acting as sort of an equity-like substitute with less risk, but were not keeping pace with equities and were a bit inefficient. “This is sitting within equities. It's really not able to keep up, but it is generating good alpha. How do we capture that and extract that? So that's when we came up with that overlay program,” she said.

In October, TRS combined portable alpha into one global program, instead of regional, that is overlaid with U.S. beta, Llano said. TRS, as a large system, runs the overlay in-house. “We have a big portfolio solutions, analytics team, and they are now in charge of the overlay. So we have the in-house resources to do it,” she said. But, Llano notes that some of their managers have started offering portable alpha strategies at the request of investors.

And Llano notes that there are some strategies like long-only credit in the program that are not per se hedge funds, but have a structural lower beta delivery, that have been incorporated.

“The experience has been very positive. Really our benchmark for success is that these portfolios can one, generate Jensen's alpha, so beta-adjusted alpha. Also if we’re doing our job, it's delivering beta-1 to the portfolio … it's met those goals,” she said.

And portable alpha is coming up more and more in conversations with peers, she added.

“I think some of it is people are looking for consistent sources of alpha and this tends to provide that. So, I think that's one of the reasons that more of our peers are looking into it,” Llano said, adding that some are using structures including separately managed accounts and managed account platforms to implement portable alpha.

After the global financial crisis, it took nearly a decade for portable alpha to begin cropping up again, said Jon Caplis, CEO of PivotalPath, a hedge fund research firm. As part of the hedge fund industry’s institutionalization, managers are sitting down with clients and creating the products they want, including using separately managed accounts.

Managers including AQR Capital Management, Man Group and Winton Group spoke with P&I to describe the approaches they are taking to portable alpha.

AQR’s turnkey approach

For AQR, the approach to portable alpha has been to provide a turnkey solution, said Pete Hecht, head of the portfolio solutions group North America. AQR began offering portable alpha over a decade ago, but only more recently writing and speaking about its approach.

“AQR offers what I call the turnkey portable alpha solution, where we do everything for you so the investment walks and talks like any other long-only investment. You give us $100, we will give you exposure of $100 to the beta of your choice, plus the alpha of your choice. All of that, cash and collateral management risk, beta estimation risk, etc., goes away with our implementation,” he said.

The structure allows investors to choose the beta and the alpha they want. Equity betas the most popular and AQR offers three flagship alpha sources in equity market neutral, multistrategy and alternative trend-following.

Hecht thinks that many investors shied away from portable alpha because “they’ve just come to the conclusion it’s too complex for their organization,” he said.

A turnkey approach “makes the benefits of portable alpha available to the masses,” he said, adding that with the firm’s approach, the performance fee is based on how much AQR beats the stated benchmark for the overall program.

“It's a really uncomfortable conversation to go in front of your board and say, I paid performance fees to my alpha providers while the entire program underperforms the benchmark,” he said. “And that can happen using the complex approach.”

But Hecht noted that the majority of investors are still using a complex approach in the space.

AQR managed $114 billion as of Dec. 31; it had $360 million in portable alpha assets under management as of March 31.

Winton and CTAs

Winton has been working with investors on portable alpha implementations for over a decade.

Simon Judes, co-CIO at $13.2 billion hedge fund manager, has seen a variety of different implementations, from being asked to provide alpha while beta is matched elsewhere to having Winton provide the strategy with an equity benchmark and implement it for a client.

Following 2008, commodity trading advisers, or CTAs, gained favor as a hedge fund strategy by performing well and it led to the first big wave of institutional investor interest in the managed futures strategies.

“We’re certainly seeing an increase in interest, and it's coinciding with the increased interest in CTAs more generally,” Judes said. “There's been a general resurgence of interest in CTAs because they've got these really favorable diversified properties over the years. Now, obviously that's the same reason that makes them really well suited to a portable alpha structure.”

In 2008, many investors were hit by a double whammy of their beta and alpha components in portable alpha both declining.

Judes said CTAs are among the only strategies that actually have had very low correlation with bonds and stocks in periods like 2022. “All of that means that as alpha strategies go, that evidence suggests that they're very well suited to playing the role of the alpha in a portable alpha strategy,” he said.

Judes thinks more allocations will follow, but cautions the conversations take time and it can be a major commitment to have a portable alpha program.

“I do expect we'll see more allocations of that kind, particularly to CTAs, because the need for alternative investments has been demonstrated clearly in a way that it hadn't done for 10 years,” he said.

Man Group’s focus on customization

Man Group has had various implementations of portable alpha for the last nine years or so, said Ed Cole, head of multistrategy equity, which sits in the solution business that helps clients structure different portable alpha offerings.

“A critical consideration is that the alpha is properly diversifying to equity where you need it most,” Cole said. “So, part of the reason that the structures were never heard of again after the GFC for such a long period of time is that what emerged during that crisis was that the correlation that was assumed between the alphas and the beta broke down under the stress of that systemic crisis.”

Cole argues it is critical for allocators to understand their alpha component and understand how it behaves at different parts of the distribution of beta risk.

“One of the reasons that we think we're in a strong position when it comes to offering orthogonal, diversifying alphas is because of the really enormous hedge fund content that we have at Man Group,” Cole said.

And one of those strategies is trend-following. “The utility of trend, is that when you take that as a multiasset implementation on its own, and you plug it in next to other things that have got higher (Sharpe ratios), perhaps, or do well in other parts of the distribution of equity returns, the blended whole becomes really robust,” he said.

While there is a place for off-the-shelf products, Cole said customizing to client needs has been central for Man’s institutional clients. “Being able to get close to our clients, understand what their specific needs and goals and constraints are, and help build something that specifically addresses their problems … that's the bread and butter of our business,” he said.

There has been a big uptick in conversations around the space and Cole warns that while portable alpha can sound simple, it is not.

“The main point is, can you do alpha at scale in a liquid way, with enough cash efficiency, in a way that is diversified from the beta. That's it. It sounds simple, it's not, but that's the trick,” he said. “And I really do think that it is not just the case of saying we've got this alpha. Let's slap it on a beta. It's really the process of stress testing how your alpha will behave in extremis is critical.”

Man Group had $168.6 billion in total AUM as of Dec. 31.