Absolute-return managers play the field to find alpha

One source of alpha no longer is good enough: Managers offering absolute-return strategies that amass gains from a host of different alphas are all the rage.

At the top of the heap is Bridgewater Associates Inc., Westport, Conn., whose $17.2 billion in assets run in its "pure alpha" strategy has more than tripled since January 2004. The strategy seeks added value from 77 sources of alpha, derived from seven broad categories.

"Bridgewater is minting money out of these strategies. They're doing phenomenally well," said Peter Gerlings, senior partner at New England Pension Consultants, Boston.

A few other firms, chiefly quantitatively driven managers, are also benefiting from the trend, including: Barclays Global Investors; First Quadrant LP; Goldman Sachs Asset Management; Grantham, Mayo, Van Otterloo & Co. LLC; Mellon Capital Management Corp.; Pacific Investment Management Co.; and UBS Global Asset Management.

"There's more demand than what the industry is able to meet," said Ken Kroner, managing director and head of global markets research at San Francisco-based BGI. BGI closed a quantitative global macro fund, launched in 2001, at nearly $4 billion; a traditional multistrategy fund started this spring has $200 million in assets and is experiencing strong demand.

Having a variety of alpha sources keeps these managers from relying on one strategy that may be in or out of favor during a particular time period. They can typically make tactical bets, moving assets to where the most promising sources of alpha are, whether they are asset classes, countries or currencies.

Plus, having multiple sources of alpha drives up the information ratio, a measure of the portfolio's efficiency on a risk-adjusted-basis. The information ratio is "very important" when talking about these strategies, "because you can't really talk about returns," said Greg Nordquist, senior consultant at Russell Investment Group, Tacoma, Wash. All of these strategies are examined in light of how much risk they're taking, he said.

Using a variety of alpha sources improves consistency of returns, eliminating wild performance swings. That's a big selling point after declining stock markets and falling interest rates threw most pension funds into deficit.

"We do actually prefer multiple sources of alpha, mainly because of the diversification reason," Mr. Gerlings said.

"Most of our client base have moved toward an absolute-return environment, where they are more focused on their liabilities. Relative returns don't fit their needs as in the past," said Brian Singer, chief investment officer at UBS, Chicago.

Officials at the $780 million Edna McDonnell Clark Foundation, New York, recognized early on that they were going to find it more difficult to meet the foundation's target return of 5.5% after inflation.

"We began to talk to UBS and others, (telling them to) forget about traditional benchmarks, think about our goals — 5.5% real over an extended period — and make sure that we are using, to the fullest extent possible, the resources of UBS' talent bank," said John M. Emery, chairman of the investment committee.

From 2002 through 2004, Clark Foundation officials converted three of the fund's global balanced mandates into absolute-return strategies, totaling 55% of foundation assets. Grantham, Mayo, Boston, was charged with investing in any of its in-house strategies, though hedge funds were capped at 20% of its total mandate. Wellington Capital Co. LLP, Boston, was given a similar brief. UBS was the last piece of the puzzle, delayed until early 2004, when the firm's "dynamic alpha" strategy had been fully tweaked, Mr. Emery said.

Wellington and UBS each manages about $135 million for the foundation, while GMO has a slightly larger portfolio.

These multistrategy products stem from domestic tactical asset allocation strategies, 1980s-era strategies that make tactical bets on U.S. equities, bonds and cash. Global versions of these strategies became somewhat successful in the 1990s, but the booming stock market limited the appeal, because they frequently sell stocks as share prices rise.

But hedge fund-of-funds — essentially a different type of multiple alpha strategy — have "warmed (investors) up to the concept," said Max Darnell, partner and chief investment officer at First Quadrant, Pasadena, Calif.

"The other thing that's happened here is an increased appreciation for the importance of breadth (making multiple types of bets) in constructing portfolios. Strategies that target single market inefficiencies or a small number of market inefficiencies are simply doomed to underperform those strategies that have access to a wider array of market inefficiencies," Mr. Darnell said.

These strategies have taken on an ever-more exotic bent. In the 1990s, First Quadrant added currency bets and, later, volatility arbitrage. The firm now manages about $10 billion in multistrategy products, more than half of which were won in the first half of 2005. Similarly, Mellon Capital, San Francisco, manages $9.7 billion in absolute-return strategies and recently launched Global Alpha II, an absolute-return strategy that actively manages exposures to global stock, bond and currency markets.

Another success story is Newport Beach, Calif.-based PIMCO's All Asset Fund, for which asset allocation decisions are made by Research Affiliates LLC, Pasadena, Calif., and investments are made in underlying PIMCO funds that invest in both traditional asset classes and alternatives. The fund, launched July 1, 2002, has doubled its assets under management since December, hitting "north of $8 billion," said Robert D. Arnott, chairman.

The latest trend is offering strategies that package bets on both market exposure and securities selection.

Clients are asking executives at Goldman Sachs Asset Management, New York, to "give me your best alpha sources plus your most diversified beta sources" and figure out how much to allocate to alpha and beta, said Mark Carhart, managing director and co-chief investment officer of GSAM's quantitative strategies group.

"The strategy looks a lot different than a traditional asset allocation. There are a relatively small amounts of equities and a large amount of absolute-return strategies, and an atypical amount of exotic betas," such as commodities or emerging market debt or equity, Mr. Carhart said.

William Mahoney, director, business development, at Bridgewater, said some clients are asking the firm to overlay its pure alpha strategy on top of its "all-weather" strategy, which makes market exposure bets only. Within the last two years, 15 clients have allocated a total of $5 billion to the combined strategies.

"That's very attractive, because ‘all weather' has a different beta exposure" than typical asset mixes, Russell's Mr. Nordquist said.

UBS' dynamic alpha more closely resembles a traditional global balanced portfolio, but also makes bets on both alpha and beta. "We take market risk when we feel that market risk is appropriately compensated, and we take active risk, or alpha, when we feel that that risk is adequately compensated within the portfolio," UBS' Mr. Singer said.

UBS runs $3.6 billion globally in the strategy, of which $2.2 billion is for institutional or high-net-worth clients. The Clark Foundation is the firm's only U.S. institutional client, but it has also raised more than $800 million from a U.S. mutual fund version launched in late January.