Porting alpha from one asset class to another is easier said than done.
Pension fund executives have grown increasingly interested in such strategies, as they search for more and better ways to add incremental returns over a given benchmark. But money managers that are hired to manage these strategies are finding implementation can be difficult.
In a portable alpha strategy, an investor will typically replicate the returns of a given benchmark by purchasing futures, and then investing the remaining cash in an alpha-generating portfolio that has a low correlation to the index being replicated.
"Portable alpha strategies make all the sense in the world on paper, but in the world of practitioners, (they are) difficult to implement due to the costs and other realities of the marketplace," said Richard Ennis, president of consulting firm Ennis, Knupp + Associates, Chicago.
"One of the biggest (difficulties is) it's hard to beat the market. Another is that there's really no accepted definition of alpha; there's really no agreement on any one particular pricing model," Mr. Ennis said. "Another problem is liquidity. In my experience, the Standard & Poor's 500 may be the only index that has futures contracts and liquidity, so it has minimal basis risk that will reliably support that kind of activity ..."
"If you have to get into the commercial swap market, there are going to be additional fees and that eats into the returns. There's also counterparty risk with swaps."
The swap is a total return swap, in which a fund will typically pay LIBOR plus a few basis points to a counterparty, usually a financial institution, in exchange for the returns of a particular index. Swaps, like futures and exchange-traded funds, can be used in a portable alpha strategy to gain nominal exposure to an index.
As Mr. Ennis noted, using derivatives instruments in portable alpha strategies can be expensive. According to an April 22 study released by Merrill Lynch & Co.'s pensions and endowments group, New York, titled "The Power of Portable Alpha," the cost to hedge out beta in a portable alpha portfolio tied to the Russell 2000 Growth index is about 175 basis points. And that cost can climb to 215 basis points, according to the study.
"If it costs 80 basis points to short, for example, the Russell 2000, most of the time it would be safe to assume that this cost would be between 30 and 130 basis points. However, at certain times, demand is so great — such as in May or June, when the index is reconstituted — this cost could easily exceed 150 basis points," according to the study.
The money managers being hired to implement these strategies acknowledge that replicating certain indexes is difficult, but not impossible. They noted the futures market for certain indexes, such as the Morgan Stanley Capital International Europe Australasia Far East and the Lehman Brothers Aggregate bond, are not liquid, and in some cases, don't exist.
They also acknowledge it's difficult to construct an alpha-generating portfolio that has a low correlation to a given index because most investments contain some sort of broad market risk.
"The issue of futures contracts to add … beta has been a problem that's been around for an extended period," said Robert Blackwell, managing director of research at the Russell Investment Group, Tacoma, Wash. "We have known for a long time that some markets are tough to cash equitize."
In the futures market, liquidity has improved dramatically in the past three years, making it easier to implement portable alpha strategies, Mr. Blackwell said. "Three years ago, the Russell 2000 index futures market was trading about $600 million a day. Today, that's well over $6 billion a day."
The one risk portable alpha investors must be wary of, he said, is basis risk. When an investor buys a basket of futures with the intent to replicate a given index, the investor runs the risk that the correlation between the basket of futures and the given index becomes too low. Put simply, the futures might not be reflecting the actual price of the index.
Stephen Boxer is fixed-income product manager at Babson Capital Management, Boston, a firm actively seeking to build portable alpha strategies, including one tied to inflation. He said the Lehman Brothers Aggregate and the MSCI EAFE indexes are particularly difficult to replicate. With the Lehman index, he said, "you can buy the underlying components of the index, except for the corporate bonds. The corporates in the Aggregate, in some cases, are being held by large insurance companies that aren't going looking to sell them."
Joanne Hill, managing director of equity derivatives research at Goldman Sachs & Co., New York, said replicating indexes has become less difficult. "I'm seeing that the swaps market is being used more and more for certain indexes where futures don't exist. As long as there are tradable securities underlying the index, there is a way to replicate it. A year ago the equity swap market was not being broadly used, but it has become more popular. A lot of it is related to the popularity of alpha transport vehicles. A lot more creative solutions are being found."
Phil Green, senior portfolio manager and liquidity trader at Merrill Lynch Investment Managers, Plainsboro, N.J., said, "The futures market for many indexes is a lot more liquid than it was 10 years ago." MLIM is developing customized portable alpha strategies for institutional clients.