| Portable Alpha 101 |
|
|
| 10/10/2004 | |
|
This week's 101 by François-Xavier Douin at JPMorgan Fleming AM seeks to explain the "portable alpha" strategy. An absolute return strategy alongside other asset classes such as hedge funds, emerging market equity, or corporate high yield bond, François-Xavier Douin describes a strategy whose main purpose is to enhance and spread out the overall alpha of a given portfolio. According to JPMorgan Fleming's latest survey on new sources of return, 37% of European institutions have, or plan to adopt a portable alpha strategy. 1-What is a "portable alpha" strategy? A portable alpha strategy involves carrying the outperformance (alpha) generated through active management on a given asset class, over to another. Typically, it would involve using derivatives to hedge the market component (beta) of the return of an active strategy, and then build exposure to the market where one aims to "port" the alpha. Alternatively, it could mean "equitizing" the alpha of an absolute return, or Libor +, strategy by swaping Libor return against the return of the desired market. Example 1: An active manager generates an alpha of 200bp p.a. over the Topix index, with a tracking error of 300bp. Japanese equity exposure is hedged through selling Topix futures. Exposure to the US equity market is then gained though the purchase of S&P500 futures. The net return obtained is S&P500 + 200bp, with the same tracking error as the initial Japan equity strategy. Example 2: A Hedge fund strategy generates an alpha of 600bp p.a. over Libor, with volatility of 10%. $10m are invested in the strategy. The investor then enters into a swap where Libor return is paid and Lehman Aggregate return is received, for a notional amount of $10m. The client also has a $90m passive Lehman Aggregate mandate. The net return obtained on the combined $100m is Lehman Aggregate + 60bp, with an associated tracking error of 100bp. Note: The two examples above do not take account of transaction costs. 2-What kind of institutional investors is it designed for? How much of its portfolio should an investor allocate to it? Alpha transport should appeal to a vast majority of investors. As it involves hedging/building market exposure through derivatives such as futures or swaps, those instruments will need to be authorized by internal investment policy and guidelines; robust risk management procedures will also need to be implemented. All investors who believe in active management could potentially be interested to "spread out" the alpha generated on those asset class which are deemed less efficient, or where potential for alpha is high (such as small cap or emerging market equities), on asset classes where generating high alpha is more challenging (such as US equities or treasury bonds). A great advantage of alpha transport is to untie the amount of alpha generated from the amount invested in a given asset class, thus allowing investors to optimize more freely between beta returns and alpha returns. 3-Are there any limitations to this strategy in the current market environment? A close look at transaction costs is necessary, especially on those illiquid markets where no exchange traded futures are available, when OTC derivatives will be needed, so that exchanging the returns of two markets does not eat too much of the alpha away. The current environment is favourable for portable alpha strategies, as more and more instruments are available to implement them. Also, despite an increased globalization of markets, it is widely admitted that some areas of inefficiencies do and will persist. |
|
Articles of the same Serie : 101 |
|
Articles of the same Topic : Portfolio management |
|
© Copyright 2008 bfinance. This document is for your personal non-commercial use. Any further copying, reproduction, distribution is strictly prohibited. To obtain permission please contact This e-mail address is being protected from spam bots, you need JavaScript enabled to view it