| Separating the market chaff from the alpha wheat |
|
|
| 22/01/2006 | |
|
Increasingly efficient markets means harder to churn alpha – so should investors trust fund managers selling active management funds with a S&P 500 benchmark, one of the most liquid around? That might be a bit too much to ask for many schemes, fed up with paying high-priced active fund managers for little more than what the market can provide by itself. The portable alpha approach, the basic principle of which is to separate the alpha and beta sources in order to allow a better management of the risk budget, is one of the solutions offered to investors facing those problems. For instance, a €250 million investment in an active US large cap fund with a S&P 500 benchmark will get its investor market return, plus whatever alpha generated by the manager's own stock picking decisions. The beta and the alpha are completely intertwined, and the investor has to pay for active management fees that are highly dependent on market performance. That also makes it hard for the investor to have a thorough understanding of whether he gets exactly what he has paid for. "In traditional active management, clients have realised that they have constrained their managers too much both in style and not allowing short sales", says Alistair Lowe, director of global asset allocation at State Street Global Advisors. "Managers can't do much about that since their clients fire those who don't stay within their stylebox." With hardly a month without a survey confirming the steady rise of alternative assets amongst Europe's pension portfolio, as well as the move away from balanced management, institutions are now clearly voting in favour of high-alpha strategies with their assets. But alpha hungry investors still face the problem of integrating those strategies in traditional portfolios. According to Credit Suisse Asset Management, the last ten years have witnessed the creation of a veritable "alpha" industry, but "strategies that have truly provided alpha are hard to find, and once found, difficult to incorporate into the portfolio based on investment policy constraints." That's where the portable alpha approach, which allows seamless integration of high alpha strategies into a portfolio without completely overhauling the original asset mix, comes in. "There needs to be something between the traditional institutional management style and the hedge fund "black box", and strategies such as portable alpha can fit between those two extremes in terms of transparency and risk control", says SSGA's Alistair Lowe. Besides the separation of alpha and beta objective that is attained at the expense of middle-of-the-road solutions such as actively managed funds heavily correlated to the market, the basic idea behind the "portable alpha" strategy is to use derivatives to free up space for high-alpha assets. "Derivatives are the easiest way to put in place a portable alpha", says Philippe Mimran, head of balanced funds at Axa Investment Managers in Paris. That is also one of the single most important differences with traditional managers, who are not allowed to go short. In the hypothesis at the beginning, instead of investing the €250 million in the active fund, a somewhat smaller investment of €225 million could be made in a less expensive passive fund tracking the S&P 500, thus providing the investor with the main market exposure he was looking for at a very low cost. The remaining €25 million would be set aside for an investment in high alpha strategies overlayed with an equivalent amount of synthetic exposure to the index gained though index futures or swaps, which can be traded for a fraction of the physical index security. For instance, according to Credit Suisse AM, index futures contracts can be purchased for approximately 5%-10% of the cost of the physical securities. In turn, the €25 million exposure to the S&P 500 could be gained through a €2.5 million investment in derivatives. The rest can be invested in alpha strategies such as hedge funds. On the downside, the use of derivatives to create exposure is a risky strategy that can lead to substantial losses. Yet, the risk is far from being disproportionate. "Regarding the use of derivatives, the main risk is the counterparty one, but it can be easily managed through collateral agreements" says Axa's Philippe Mimran. In the end, the investor still has the equivalent of a €250 million exposure to the S&P 500, and can invest freely €22.5 million in high-alpha strategies. Hedge funds, which are supposed to be heavily decorrelated from the market, will be a prime destination for the liquidities. However, it is not the only one. Thanks to the process of "alpha purification" - by all means another form of alpha portability - through swaps or future selling, the beta exposure of correlated assets can be sold off and its alpha overlayed to whatever assets that are chosen by the investor. J.L. |
|
Related articles |
|
Articles of the same Topic : Alternatives |
|
© 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