Portable alpha strategy continues slide, but fans stay optimistic

Portable alpha, a strategy that garnered pension fund fans by leveraging a dollar of assets into two dollars worth of market exposure, ended the past year down but not out.

Proponents argue the strategy — or at least its more conservative iterations — may yet reclaim some of the buzz portable alpha enjoyed in the run-up to the recent financial crisis.

As of Sept. 30, 2009, big U.S. pension funds reported $23.16 billion of assets in portable alpha strategies, off 43.5% from the year before, according to Pensions & Investments' latest survey of the top 200 U.S. retirement plans.

The year-earlier figure of $41 billion, meanwhile, itself represented a 19% drop from the peak of $50.3 billion reported as of Sept. 30, 2007.

Those declines reflect continued fallout from 2008 and early 2009, when portable alpha programs that used futures or overlays to get beta exposure to stocks while tapping alpha sources such as hedge funds of funds faced a double whammy.

Declines of more than 40% for U.S. and international stock indexes left plan executives scrambling to come up with hundreds of millions or even billions of dollars to cover margin calls on their beta exposure, at a time when plunging valuations and illiquidity were limiting their ability to rustle up the needed money.

On the alpha side, too many strategies offered under the rubric of “absolute return” turned out to be anything but, suffering surprisingly big losses of 15% to 20%.

That painful combination prompted a number of plans to dismantle multibillion-dollar programs during the survey period, including the Pennsylvania State Employees' Retirement System, which had $5.2 billion in the strategy as of Sept. 30, 2008, and the Pennsylvania Public School Employees' Retirement System, with $4.6 billion.

The Massachusetts Pension Reserves Investment Management Board, which reported $2.45 billion in residual portable alpha assets as of Sept. 30, was in the process of unwinding its program following a board vote in August to end it.

For Boston-based MassPRIM, which had to spend more than $1 billion topping up its beta overlays during the turmoil of 2008, portable alpha is “definitely out of the playbook,” said Michael Travaglini, the $41.76 billion state fund's executive director.

That's partly a timing issue, as MassPRIM's program only had a year or so of positive markets before the financial crisis struck, said Mr. Travaglini. For boards of trustees with programs in place for 10 years or so, 2008 may not necessarily have changed their thinking, he said.

Portable alpha served Pennsylvania SERS well for more than six years, but proved flawed under extreme economic conditions, with the hedge funds of funds employed unable to avoid losses or fully provide the liquidity needed to settle swap contracts, said Robert Gentzel, spokesman for the $25.6 billion Harrisburg-based system. These weaknesses were serious enough that PSERS executives wouldn't contemplate a return to a portable alpha strategy based on that model, he said.

Other plans, however, while likewise suffering mightily in recent years, appear willing to give portable alpha another try.

For example, last year the Iowa Public Employees' Retirement System dismantled its $1.6 billion program, with its latest annual financial report attributing “nearly all” of the annualized 1.8 percentage points of underperformance by the fund's domestic equity portfolio over the past five years to its portable alpha strategies.

Still, in December the $19.65 billion fund hired Pasadena, Calif.-based First Quadrant LP to manage a $200 million active global portable alpha mandate, after issuing a request for proposals emphasizing the need for an alpha source with no correlation to major stock or bond indexes. Karl Koch, Iowa's chief investment officer, didn't respond to requests for comment.

Keith H. Black, a manager research associate with Chicago-based investment consultant Ennis Knupp & Associates, said finding an alpha engine with reasonably low volatility that's uncorrelated to the underlying beta is a key to making the strategy work. Ennis Knupp has recommended portable alpha strategies that used short-term, high quality fixed income as an alpha source, capable of delivering incremental returns of a percentage point or two above S&P 500 beta exposure, he said.

A number of big portable alpha clients agree that the strategy remains an attractive option if implemented conservatively.

In recent years, “the only thing that really went wrong ... was assuming that your alpha engines were more stable and uncorrelated than they were,” said Robert L. Borden, CIO of the South Carolina Retirement Systems, Columbia, which trimmed its portable alpha program to $3.9 billion from $5.3 billion over the 12 months ended Sept. 30.

Mr. Borden said South Carolina is in the process of “bifurcating” its hedge fund investments, seeking out “true absolute return strategies” suitable for its portable alpha program. Those hedge funds will offer lower but more consistent returns of perhaps 300 basis points over the London interbank offered rate, he said, adding that South Carolina is seeking tighter control of its alpha engine by emphasizing direct hedge fund investments over hedge funds of funds. The system had $23.75 billion as of Sept. 30.

Other investors say they came into the recent financial crisis with portable alpha programs that were able to roll with the market's punches.

Even with a difficult year in 2008, portable alpha has been “a really successful strategy” for United Technologies Corp., helped by the way the program has been constructed, said Robin L. Diamonte, chief investment officer and director of pension investments for the Hartford, Conn.-based company's $15 billion in defined benefit assets.

A combination of liquid, unleveraged, market neutral, low cost and low volatility funds for the program's alpha component has added value since the portfolio's inception in 2006. The portable alpha strategy detracted from performance in 2008, but the following year's rebound more than made up the difference, she said.

Moreover, the flexibility of the portable alpha strategy has allowed excess gains to be ported over various asset classes. During the life of the strategy, this has included long duration bonds and global equity as UTC's asset allocation has changed, Ms. Diamonte said.

The Seattle-based Western Conference of Teamsters' $3.1 billion portable alpha program was similarly well-positioned to withstand the market's fireworks, said Alan D. Biller, president of the $26 billion union fund's investment consultant, Alan D. Biller & Associates Inc., Menlo Park, Calif.

The domestic portion, combining S&P 500 beta with alpha from an unleveraged convertible arbitrage hedge fund, and the international portion, combining EAFE beta with alpha from a global long/short tactical asset allocation strategy, employing currency, stock and bond futures, maintained enough reserves and liquidity to avoid drawing on the broader portfolio's resources as markets plunged in 2008, Mr. Biller said. Both strategies then rebounded smartly in 2009.

In an e-mailed response to questions, James Grossman, managing director of external public markets, risk and compliance with Pennsylvania's Public School Employees Retirement System, said PSERS hadn't anticipated the market plunge of 2008, leaving investment staff there scrambling to raise liquidity in a difficult environment, but that was an implementation issue, rather than a fundamental flaw of portable alpha. With better construction, the strategy could be an attractive one, he said.