Following the announcement of the Pennsylvania State Employees Retirement System (SERS) that it lost money using portable alpha, the strategy’s usefulness has come under question. But does SERS’ widely publicised view of portable alpha amount to an indictment? Not according to a number of high profile investors. Bridgewater Associates actually enjoyed some success using the strategy during the 2008 downturn. Its flagship fund called Pure Alpha returned 14% last year.

Sweden’s AP7 is another proponent of the holistic approach of alpha/beta separation, awarding alpha briefs in recent years that are essentially notional overlays applied to the fund’s passive portfolio. During last year’s downturn, the fund’s traditional long-only mandates underperformed their pure alpha briefs, notes Svante Linder, Head of Fund Administration at AP7. “Four out of our six portable alpha mandates had positive returns, while five out of six long-only mandates underperformed their benchmarks. The main advantage of alpha/beta separation is better performance. We also have a better overview and understanding of what parts of the overall performance come from the strategic asset allocation (beta) and what parts come from active management.”

AP7’s aim is to establish a framework to assess how market returns (beta) and attempts to add value (alpha) contribute to performance. “Over time, we expect investors to push active managers to adopt more transparent and cost efficient alpha-beta separation,” notes Richard Grötheim, CIO of AP7 and co-author of Alpha-Beta Separation: From Theory to Practice. “Attempts to add value can be achieved in the form of pure alpha strategies where a manager’s positions reflect only relative value insights. For example, an active manager specialising in stock selection might hold a collection of long and short positions that reflect their valuation insights, but represent no net market exposure.” The board of AP7 decided to pursue a strategy of alpha/beta separation in 2005.  The main change was a complete specialisation approach in the daily investment operation. Beta specialists were already in place and the new regime focused on finding pure alpha specialists.

Risks and challenges

A historical evolution of portable alpha is provided by Dr. Rob Brown in a report titled Birth, Death, Rebirth: “Portable alpha is an alternative organisational structure by which institutional investors can select, arrange, and manage the component parts that comprise their aggregate portfolios. The implementation of portable alpha entails several key elements: the hiring of active managers (the alpha generators); the evaluation of each manager’s market exposures (betas); defining the structure of each manager’s liquidity needs; structuring the technical terms of derivatives contracts. Some portable alpha adopters experienced disappointment in 2008 because they had implementation gaps in one or more of these four areas…some misunderstood how positively correlated their different alpha sources were.”

There are a number of risks associated with portable alpha, including alpha volatility, failure to diversify alpha sources, presence of beta within the alpha source, insufficient liquidity to feed futures contracts, active management risk, counterparty risk, the use of derivatives/leverage to hedge out market risk, and the impact of fat tails on alpha strategies. Key decisions must be made whether to hire separate alpha and beta managers and how high to set the alpha target.

Despite these challenges, the death of portable alpha is exaggerated. “Portable alpha came into existence because a new organisational structure was needed to make better use of alpha opportunities and to a somewhat lesser extent to take advantage of derivatives’ advantages over physicals,” says Brown. “We believe that forward-looking alpha opportunities are likely to be the largest in our professional careers. Moreover, the high and long-lasting uncertainty that has been injected into the global capital market and macro economy establishes an environment where the rewards to future betas are more uncertain than the historic norm. This coincidence of factors significantly increases the need for optimal alpha capture and lower cost beta delivery.” Pension funds are taking heed: a bfinance survey in March 2009 showed a somewhat higher percentage of pension funds who expect an increase in their portable alpha allocation in the coming years compared to the results of a similar survey six months earlier.

V.B.