Lower returns put portable alpha in better light

Institutional investors are expanding their portable alpha programs in hopes of beefing up anemic stock and bond returns.

While the virtues of portable alpha have been preached for years, it's only since investors woke up to the harsh new realities of lower expected returns that they've been pursuing these strategies in earnest.

In these strategies, investors try to find consistent sources of alpha — the risk-adjusted return above a set benchmark. They short out the market exposure of the alpha source, and then port the alpha onto a readily available market exposure, or beta, usually through a derivatives contract.

For example, a pension executive might believe a small-cap equity manager can produce alpha while large-cap equity managers cannot because pricing of large-cap stocks is very efficient. The fund would hire the small-cap manager, short the Russell 2000 index, and then port the alpha onto a Standard & Poor's 500 index strategy, such as an exchange-traded contract, a futures contract or a swap.

Among those building up their portable alpha programs:

• International Paper Co., Stamford, Conn., whose $6.6 billion pension fund plans to expand its $330 million program, said Robert Hunkeler, vice president for investments;

• The $1.4 billion Wisconsin Alumni Research Foundation, Madison, which is in the process of developing separate portfolios of alpha sources and beta sources, said Tom Weaver, director of investments;

• Bedrijfstakpensioenfonds Metalektro, Schipol, Netherlands, which plans to increase the portion of its risk budget dedicated to portable alpha to 30 to 40 basis points on the entire €16 billion ($19.5 billion) pension fund, up from 10 to 15 basis points now, said Paul van Gent, portfolio manager.

• The $3.1 billion University of Virginia endowment, which plans to use portable alpha strategies as a way to keep beta exposures in line with the fund's newly revised investment policy while seeking to maximize alpha, said Christopher Brightman, chief executive officer for the University of Virginia Investment Management Co., Charlottesville, Va.

The nation's biggest pension funds are jumping on the trend. According to a survey by JPMorgan Asset Management, New York, 33% of large U.S. corporate pension funds already use portable alpha strategies, while 23% are considering adopting such strategies.

Only 15% of public funds employ such strategies, although a staggering 37% are weighing their adoption, according to the survey of 120 of the top 350 U.S. pension funds (Pensions & Investments, May 16).

Most pension funds have relatively small allocations to portable alpha strategies, experts said. "The most sophisticated clients are doing it in size, and moving in that direction very quickly," said Mark Carhart, managing director and co-chief investment officer of the quantitative strategies group at Goldman Sachs Asset Management, New York.

Investors are looking to a variety of sources to find alpha. Mostly, they're turning to hedge funds. But they're also using short- and long-term duration strategies, Treasury inflation-protected securities, currency absolute-return strategies and global tactical asset allocation strategies.

Joe Nankof, a partner at Rocaton Investment Advisors LLC, Norwalk, Conn., said his firm divides alpha sources into three categories: arbitrage strategies, such as merger arbitrage and convertible arbitrage; macrolike strategies, such as global tactical asset allocation; and securities selection, including equity market-neutral, long-short, distressed debt and credit long-short.

In the past 2 1/2 years, Rocaton has been de-emphasizing arbitrage strategies because of their limited capacity and the amount of money flowing into those strategies, he said.

The International Paper fund has had a portable alpha program in place for two years, using three hedge funds of funds to generate alpha. The hedge fund alpha is ported onto a Standard & Poor's 500 index overlay managed by NISA Investment Advisors LLC, St. Louis.

Since inception on June 1, 2003, the managers — UBS O'Connor LLC, Chicago; Ramius Capital Group LLC, New York; and Blackstone Alternative Asset Management, New York — collectively have met the low end of the fund's return expectations of outperforming the S&P 500 index by two to four percentage points, Mr. Hunkeler said.

At $330 million, the program represents one-fifth of the fund's equity exposure. Mr. Hunkeler said he plans to increase the program but declined to provide specifics.

As use of portable alpha strategies has become more widespread, the strategies themselves have become more complex. Instead of picking one source of alpha and transporting it onto an asset class that is viewed as very efficient, such as U.S. large-cap stocks or fixed income, some institutions are completely separating alpha from beta — in effect, running them as two separate portfolios.

"Today, it's separating the alpha and beta portfolios completely, having two different portfolios that have no relationship to each other," Mr. Carhart said.

The Wisconsin Alumni Research Foundation is doing just that. Mr. Weaver said he's building a portfolio of alphas and a portfolio of betas. He plans to have eight different managers in his alpha pool.

Bridgewater Associates Inc., Westport, Conn. is unusual in being in both portfolios: the fund invests in Bridgewater's pure alpha fund, as well as its "All-Weather" portfolio, which provides beta exposure. The fund also uses the Clifton Group, Minneapolis, for overlays and rebalancing. Mr. Weaver declined to provide more detail.

Many experts say, however, that portable alpha strategies require institutional investors to be astute in picking their managers and can be expensive to implement.

William Jacques, chief investment officer at Martingale Asset Management, Boston, said some investors are intrigued with the prospect of picking hedge fund managers that can generate a 500-basis-point premium over Treasury bills, and porting that return onto an equity-index return.

"But I think some people confuse the two: they think the 500 basis points in hedge fund alpha is something that is highly likely, whereas it's highly unlikely to get a bunch of managers who will get 500 bp" from skill-based returns, he said.

Rick Dahl, chief investment officer of the $6.5 billion Missouri State Employees' Retirement System, Jefferson City, agreed. "Our view is that finding alpha is a very difficult thing to do, especially in a marketplace where people are of the belief that returns from the traditional stock and bond universe are going to be in the mid-single digits at best.

"All that everybody wants to do is talk about alpha. But the reality is that for every winner in this game of alpha, there's a loser. And, net of all the fees that are being paid, our research suggests that there are probably more losers than there are winners," he said.

Mr. Dahl said some pension executives seem to think that the availability of hedge funds is going to increase their chances of generating alpha. But he believes "the more money that flows into these strategies, the more difficult it's going to become."

The key to generating alpha, he said, is finding skillful managers and "giving them the freedom to think very broadly about how to make money."

Mr. Dahl was reluctant to discuss details of MOSERS' investments, but he did acknowledge that more than 20% of the total fund is invested in portable alpha strategies. He said Bridgewater is a manager but declined to discuss others.

MOSERS has a number of strategies that are often used to provide alpha in portable alpha strategies.

As of June 30, 2004, the fund had $336 million invested with 20 hedged equity managers, according to the fund's fiscal 2004 annual report. The fund also had $343 million invested with 36 market-neutral managers.

The Missouri fund also had $202 million invested in an enhanced Goldman Sachs Commodities Index portfolio managed by NISA Investment Advisors. Several experts noted many plan sponsors port alpha onto commodities indices.

The costs of hedging the beta also can be significant, sometimes eliminating the alpha, said Deb Boedicker, principal, Strategic Investment Group, Arlington, Va., which assembles hedge funds of funds for its clients.

Gordon Latter, pensions and endowments strategist at Merrill Lynch, New York, quantified those costs in a recent paper published by the firm. He noted that exchange-traded funds, futures contracts and total return swaps are used in executing portable alpha strategies. But costs can vary significantly. For example, shorting the Russell 2000 index costs about 80 basis points but can range from 30 basis points to 130 basis points.

"However, at certain times, demand is so great, such as in May or June when the Russell 2000 is reconstituted, this could easily exceed 150 bp. Thus, the timing of when to execute a portable alpha trade is vital," he wrote.

Nor is it simple to strip out the market effect from hedge funds, said one corporate pension executive, who asked to be unnamed. Say the pension fund invests $1 million with a hedge fund benchmarked to Treasury bills and that has a stock market beta of 0.4. At first glance, one might short 40% of the exposure, or $400,000. But if the hedge fund manager is leveraged five to one, then a $400,000 short might not be the correct market exposure, he said.

"What I find strange is that people focus on that term ‘hedge fund' and don't look at the total result. Have you managed to minimize the cost? Have you picked things that produce excess return at the total fund level? When people focus on that, they might ask whether some hedge funds are delivering," said Mr. van Gent of the Dutch metalworkers' fund.