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Benefits and Pensions MonitorMaking Portable Alpha Pay Off
The concept of portable alpha is gaining widespread acceptance among institutional investors as a cost-effective way to improve returns, manage risk, and adjust portfolio exposures. While the use of portable alpha has been a mainstream practice for many years – mostly through futures-based enhanced indexing strategies – the opportunities today are more sophisticated and diverse. Plan sponsors can ‘unbundle’ many traditional, fully funded positions into alpha and beta components and meet policy objectives with unprecedented flexibility, economy, and precision. The expanded choices, however, place increased demands on the expertise of money managers and the due diligence of investors. For example, using derivatives to track custom benchmarks requires in-depth understanding of the theoretical and practical aspects of the underlying asset classes (tracking error, liquidity). Also, the preferred strategy may require swaps instead of futures contracts to minimize tracking error. However, swaps are private contracts, unlike futures, and have counter-party exposure that must be properly managed. Increase Return The advantages of portable alpha can be explained theoretically, but we believe practical applications illustrate the concept better. The following example highlights one of the approaches we have taken to maximize the benefits of portable alpha strategies. A client was seeking to diversify the alpha produced by its U.S. large cap active equity managers, which was highly correlated across alpha generating processes and to the underlying beta exposure. To accomplish this goal, the client decided to move half of the plan’s large cap equity assets from active to passive, and then use the alpha derived from an active currency strategy to ‘port’ onto the passive exposure. Active Currency Strategy The client transferred the assets that had previously been allocated to traditional active large cap managers to an S&P 500 index strategy designed to match the performance of the S&P 500, which is the plan’s large cap benchmark. This portable alpha strategy is particularly efficient from a cash management standpoint if the active currency strategy utilizes currency forward contracts to effect currency transactions. When the strategy is implemented as an overlay (as opposed to a fully funded total return strategy), no up-front cash or collateral is required to establish active currency positions. Cash flows occur around the periodic forward contract settlements when gains/losses are realized (typically on a quarterly basis). At the time of settlement, cash is invested/divested accordingly from the underlying assets (or from another source, based upon the client’s preference). The client maintains low-cost beta exposure to the U.S. large cap portion of its plan, while the active currency strategy provides a source of alpha. The plan achieves diversification of alpha sources relative to its active large cap managers and to the underlying S&P 500 index exposure. Old Paradigm Ralph P. Goldsticker III is managing director, research, at Mellon Capital Management. |
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The alpha portion is derived from an active currency strategy, which is achieved through an overlay account. To ensure a seamless transfer of the alpha, the notional value of the overlay was set to match the value of the index fund. Active risk (tracking error) for the active currency strategy was set at two per cent, with an expected information ratio of 1.0 over the longer term. 