Chapter 1 Portable alpha: A PRACTITIONER’S GUIDE Unravelling the hype behind the latest phenomenon by Jack Coates, Ph.D., CFA and Mark Baumgartner, Ph.D, CFA, Morgan Stanley Alternative Investment Partners* Every now and then, there is a development in the world of finance that results in a major paradigm shift. Examples include the introduction of present value as a tool in financial decision making, 1 the Modigliani-Miller hypotheses regarding capital structure 2 and the introduction of modern portfolio theory in investing. 3 Today, we are in the midst of an unusual situation in which three paradigm shifts are emerging simultaneously. Each can have a significant impact on the management of the investment portfolios of pension funds, endowments and foundations. The first of these developments is a growing focus on various types of asset-liability risk. The second is the recognition that defined benefit plan and endowment or foundation assets and liabilities are part of the capital structure of the sponsoring entity; they are thus subject to both corporate or trust financial principles and optimal portfolio theory. The third development is the use of portable alpha financial engineering techniques to help raise returns, reduce portfolio volatility, and/or achieve better asset-liability matching. WHAT IS PORTABLE ALPHA? Portable alpha has been the focus of much media attention recently. The number of articles mentioning portable alpha has grown tenfold in the last three years, nearing the threshold of two new articles per day. What is driving this attention? As is true of any new idea or methodology, there is an incubation period during which it is vetted and tested by a few leading practitioners. As adoption accelerates and success stories spread, acceptance of the methodology occurs, often driven at exponential rates by word of mouth transmission. The media plays a key role at this dissemination of information stage. While we are still in the early stages of the portable alpha lifecycle, we are witnessing increasing adoption of these strategies by all types of institutional investors in a variety of sizes and approaches. 1
Transcript
Chapter 1
Portable alpha:
A PRACTITIONER’S GUIDEUnravelling the hype behind the latest phenomenon
by Jack Coates, Ph.D., CFA and Mark Baumgartner, Ph.D, CFA, Morgan Stanley Alternative Investment Partners*
Every now and then, there is a development in the world offinance that results in a major paradigm shift. Examplesinclude the introduction of present value as a tool infinancial decision making,1 the Modigliani-Miller hypothesesregarding capital structure2 and the introduction of modernportfolio theory in investing.3 Today, we are in the midst ofan unusual situation in which three paradigm shifts areemerging simultaneously. Each can have a significant impacton the management of the investment portfolios of pensionfunds, endowments and foundations.
The first of these developments is a growing focus onvarious types of asset-liability risk. The second is therecognition that defined benefit plan and endowment orfoundation assets and liabilities are part of the capitalstructure of the sponsoring entity; they are thus subjectto both corporate or trust financial principles andoptimal portfolio theory. The third development is theuse of portable alpha financial engineering techniques tohelp raise returns, reduce portfolio volatility, and/orachieve better asset-liability matching.
WHAT IS PORTABLE ALPHA?
Portable alpha has been the focus of much media attention
recently. The number of articles mentioning portablealpha has grown tenfold in the last three years, nearingthe threshold of two new articles per day. What isdriving this attention? As is true of any new idea ormethodology, there is an incubation period duringwhich it is vetted and tested by a few leadingpractitioners. As adoption accelerates and successstories spread, acceptance of the methodology occurs,often driven at exponential rates by word of mouthtransmission. The media plays a key role at thisdissemination of information stage. While we are stillin the early stages of the portable alpha lifecycle, weare witnessing increasing adoption of these strategiesby all types of institutional investors in a variety ofsizes and approaches.
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Chapter 1
Almost as fast as media coverage of portable alphahas grown, so has the variety and scope of definitionsof portable alpha. Our definition is as follows:
Portable alpha is a financial engineering methodologythat seeks to add low correlation sources of return(alpha) to a portfolio while maintaining the totalportfolio’s desired systematic (beta) exposures.
An example is combining the returns from a low-riskfund of hedge funds (the alpha) with the returns from afixed income or equity index (the beta) with theobjective of outperforming the index by somemeaningful amount with minimal additional risk.
Part of the confusion surrounding portable alphaarises from the many ways it can be implemented,although this flexibility is also one of its mostattractive characteristics. With portable alpha, almostany robust source of alpha can be transported to
virtually any asset class – including cash, all types ofequity and fixed income vehicles, and other categoriessuch as commodities.
Alpha may be transported to (1) any market index forwhich established derivatives markets exist, (2) anyasset class that can be replicated using baskets ofsecurities, or (3) any asset class for which an active orpassive manager exists. A single, diversified portfolio ofalpha-generating strategies can also be transported tomultiple benchmarks simultaneously, making theprocess of alpha generation more efficient than wouldbe the case if alpha had to be found separately for eachasset class.
Portable alpha vs. the traditional approach The traditional approach to institutional investmentmanagement begins with a committee setting target assetclasses, and then choosing index funds or activemanagers within each class in the hope of finding those
The portable alpha approach
Source: Morgan Stanley Alternative Investment Partners
Exhibit 1
Beta1
from index oractive manager
benchmark
Alpha, fromfund or hedge funds
or privateequity funds
Embeddedbeta2
Alpha
Beta1 + beta2
Primary betasource
Alphaengine
Totalreturn+ =
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that are able to generate alphas above the passive assetclass returns. For example, to fill a target equityallocation, investors would search only among equitymanagers; for a bond allocation, they would search onlyamong bond managers. By focusing exclusively onmanagers within each class, however, investors limit theuniverse of strategies and managers from which to selectand, hence, the opportunities to find the desired levels ofalpha. Allocations to managers capable of generating thegreatest alphas are excluded if they do not fit within theconfines of the chosen asset classes.
Portable alpha works quite differently. It is predicatedupon the notion that portfolio objectives are bestachieved when asset class decisions and managerselections are made independently. It is further basedupon the separation of market-based and skill-basedreturns, and allocating most of a fund’s activemanagement risk budget to alpha sources.
A typical portable alpha strategy begins by selectinga well-diversified portfolio of the best alpha-generatingmanagers, regardless of the asset classes in which theyoperate, with adequate consideration given to liquidityand risk. Once an attractive mix of managers isidentified, the embedded market exposures (betas) inthe portfolio are assessed. The investor then creates anoverlay, employing futures, options, swaps or othercontracts to add or subtract beta exposures toparticular asset classes in order to achieve the desiredtotal asset allocation. The objective is to set theoverlay exposures so that they and the exposuresembedded in the alpha sources sum to the investor’starget exposures (see Exhibit 1).
ADVANTAGES OF PORTABLE ALPHA
Portable alpha can provide a superior mix of alphas,while still achieving the desired aggregate betas.Although portable alpha can be challenging toimplement and can add new management requirements,
there are distinct advantages compared with traditionalportfolio management, including:
An expanded universeInvestors are not forced to seek alpha only frommanagers within the target asset classes, opening a vastfield of possible high-alpha strategies, such as certaintypes of hedge funds, private equity and opportunisticreal estate, as well as a few traditional strategies.
More tailored exposuresThe least efficient markets typically offer the bestopportunities for alpha, but they might entail too muchmarket risk for an investor. Portable alpha lets investorsoffset undesired exposures and/or capitalise on alphafrom sources that do not have undesired market risks.
Added flexibilityAn investor might reduce total portfolio risk by shiftingthe asset mix to one better suited to their risk objectives.For example, an allocation to equities could be reduced andfixed income and inflation-linked exposures increased,resulting in a better asset-liability match, additional inflationprotection and a reduction in overall portfolio volatility whilemaintaining or even increasing potential expected returns.
Increased efficiencyPortable alpha allows the selection of alpha generatingmanagers without regard to their asset classes.Alpha-generating managers often have low correlationswith each other and can be combined into very efficient,risk-controlled portfolios.
Reduced riskBy separating alpha and beta decisions, it is possible toallocate different amounts of a risk budget to each. Forexample, the alpha component can be large or small,unrelated to the amounts of the asset classes to which thealpha is transported. An initial small allocation to the alphasource might be increased as cumulative alpha is generated.
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Lower feesWith a portable alpha strategy, investors typically payhigher fees only to managers who add alpha, with lowercosts for beta exposures.
USING PORTABLE ALPHA IN A PORTFOLIOCONTEXT
At a recent investing conference, a consultant noted thatmany of her clients had implemented portable alpha intheir portfolios. “We have several investors already usingthese enhanced index strategies,” she said.
Claims such as these serve to illustrate the widevariety of ways the term portable alpha is currentlybeing used. While traditional lower-alpha enhancedindexing is a form of portable alpha, it is perhapsmore accurately classified as an ‘incremental active’strategy (see Exhibit 2). These types of strategies are
often just a simple exchange of ‘standard’ indexexposures with a product that closely hugs benchmarkindices. Investors who use this approach may misssome of the benefits that a more optimal portablealpha solution affords.
An optimal portable alpha solution providesthree distinct advantages over traditionalportfolio construction approaches and otherstrategies. It can:1) Add substantial additional expected returns to an
asset class or portfolio;2) Significantly decrease overall portfolio volatility;
and/or3) Facilitate a meaningful shift to asset classes that
an investor prefers when returns for suchclasses can be enhanced.
Referring back to Exhibit 2, ‘incremental active’strategies do offer a nominal additional expectedreturn over the index, or the ability to decrease
The portable alpha spectrum
Source: Morgan Stanley Alternative Investment Partners
Exhibit 2
Tracking error (!)
Alp
ha p
oten
tial (
E(r)
)
‘Optimal’ portable alpha zone
Too little return
Pureindexing
Incrementalactive
Optimalactive
Aggressiveactive
Too much risk
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portfolio volatility slightly, but they do not allowmeaningful shifts in allocations among asset classeswithin a portfolio – they are simply a good indexreplacement for investors who want to achieveslightly index-beating returns.
At the other end of the spectrum are the ‘aggressiveactive’ alpha strategies, for instance, certain types ofsingle-manager, single-strategy hedge funds that seekhigh alpha with little regard to risk. The higher volatilityof these strategies makes it more difficult to discernwhether a manager truly has skill due to theinconsistency of alpha provision. Such strategies may beappropriate for investors who have sophisticatedcontrols in place and can tolerate the risks of suchstrategies, but in many cases investors in aggressiveactive strategies end up ‘porting volatility’ to theirportfolios rather than alpha.
For most other investors, the optimal active zone is the‘sweet spot’ in the portable alpha spectrum. It provides
enough additional alpha to achieve meaningful amountsof increased return or allow meaningful risk-reducingshifts in allocations within portfolios (for example, fromequities to fixed income) while still meeting totalportfolio target returns.
SELECTING AN OPTIMAL ALPHA ENGINE
Optimal portable alpha applications offer significant benefits,but finding an alpha engine that sits squarely in the‘optimal’ zone of the portable alpha spectrum is not simple.Unlike beta risk, alpha risk does not offer the expectation ofadditional returns in exchange for the volatility assumed,even in the long term. In fact, the expected long-term alphafor a randomly selected diversified basket of alphasources is negative due to the fees an investor pays foractive management. This puts a premium on the selectionof high quality alpha sources for portable alpha applications.
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Developing and managing an optimal alpha engine using a fund of funds approach
Source: Morgan Stanley Alternative Investment Partners
At face value, portable alpha appears to be fairlystraightforward, but there is an array of complex portfoliomanagement challenges that must be faced once thealpha engine has been chosen: managing embeddedbetas, rebalancing overlays, trading sophisticatedderivatives, and dealing with leverage and liability.
Embedded betasA key term in our definition of portable alpha is ‘lowcorrelation returns’. In practice, however, most sourcesused for alpha generation contain some embedded betas– that is, they are not completely uncorrelated with theindices being used for systematic risk exposure (i.e., beta).
To address this issue, an assortment of tools must beused to estimate, monitor, and adjust the marketexposures embedded in the portfolio. Even so-calledmarket-neutral funds have some embedded betas thatmust be considered when constructing an overlay.Although there are mathematical techniques to estimateembedded betas, the betas tend to fluctuate, can beindirect and relate to other variables, can be the result ofskill that is desirable, and/or can result from othernuances. Judgement is required to determine whenfluctuations are temporary ‘noise’ versus when theyreflect a true change in the underlying economic betas.
Overlay managementAfter assessing the amounts and patterns of betas embeddedin an alpha portfolio, an investor can implement the desiredamount of additional beta exposures using futures, optionsor swaps on the desired target indices (i.e., the overlay).Selecting and sizing derivatives requires precise analysis ofmultiple factors, including pricing, basis risk, optionality
and cash management of derivative settlements. Theembedded beta exposures of an alpha portfolio can changeover time, and the sum of the embedded and derivativeexposures will drift as markets move and alpha is generated.Ongoing monitoring and periodic adjustments of theoverlay are necessary to address such effects.
Trading considerationsThe decision of how often and by what degree to adjustthe overlay can be complicated, but manageable.Derivatives used in portable alpha can have quite differentcash settlement requirements that need to be managedclosely. For example, a swap will usually require onlyquarterly interest payments, with the gain or loss settledeither at final expiration or, at the option of the investor,earlier. Futures, in contrast, require daily settlements.
Once the architectural decision has been maderegarding the kinds of derivative instruments to use forthe overlay, significant trading expertise is involved inactually implementing the desired architecture. To do thisefficiently requires close relationships with counterpartiesand brokers, in-depth knowledge of the market andderivative instruments, and experience in establishingcontracts and agreements.
Leverage and liabilityOne of the key risks in implementing a portable alphastrategy involves issues of leverage and liability.Direct implementers of portable alpha or separateaccount holders must be willing to engage in thenecessary derivative transactions. Some investors,however, prefer to invest in a commingled account – apre-packaged limited liability vehicle or special-purposevehicle (SPV) that limits the derivatives liabilityinvolved. There are costs and benefits to eachapproach, as detailed in Exhibit 4.
Locating, analysing and accessing investments for analpha-generating portfolio is very access-, labour- and
skill-intensive. The investor must have access to acontinual stream of new ideas for alpha generation,
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along with relationships with and access to top-performingmanagers. During our more than 20 years of intensefocus on locating alpha – both as a plan sponsor and afund of funds manager – we have found the mostcompelling sources to be various types of alternativeinvestments, such as selected subcategories of hedgefunds, private equity and opportunistic real estate.
The most attractive alternative strategies arecontinually changing. Further, the return dispersionbetween the best and worst performing strategies andmanagers can be very large in the field of the highalpha-generating alternatives, and the relativeperformance relationships among managers can changedramatically over long periods of time – even for‘successful’ managers with long track records. Therefore,multi-manager, diversified alpha engines provide keystrategic advantages in a portable alpha structure.
Exhibit 3 demonstrates the steps involved indeveloping and managing an optimal alpha engine
using a fund of funds approach. In essence, an investormust first thoroughly understand each strategy andconduct extensive investment, staffing, process andoperational due diligence on candidate managers.During this stage, experience-based qualitativeevaluations of the manager must be conducted as acomplement to quantitative analyses; correlations andother statistical properties among managers must beanalyzed in order to optimize portfolio efficiency andrisk, and investors must consider each manager’scapacity, evaluating the impact on returns of cash flowsinto the strategy. Finally, fees must be carefullyevaluated relative to projected alpha, and managers ofportfolios of alternatives and portable alpha strategiesmust continually monitor existing managers and searchfor attractive new ideas and managers. A fund of fundsapproach can be one attractive way to achieve thesemultiple tasks in a one-stop manner and obtain anoptimal source of alpha for transport.
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Separate vs. commingled accounts
Source: Morgan Stanley Alternative Investment Partners
Exhibit 4
Total fees can be lower depending on the pricing of service providersExpect somewhat higher fees commensurate with value provided bycommingled manager
Fees
Higher minimum investment requirementsCan have low minimumsMinimums
Constraints at underlying manager levelConstraints at both commingled and underlying manager level Liquidity
May be lower because creditworthiness of sponsor can be used innegotiating swaps
Financing costs
Requires an enhanced level of expertise Internalexpertise
Would require internal or external resources to manage betaand alpha exposures
No need for additional staff to manage and monitor Staffing andresources
Typically requires more disclosure of components of portable alpha One line accounting might be possible depending on accounting rules Disclosure
Liability extends to the total alpha and beta exposure Liability strictly limited to investment amountLimited liability
Beta choice can be much broader and dynamic subject to availability Restricted to the beta of commingled vehicleBeta flexibility
Composition of alpha engine can be tailored to clients needs and adjusted Restricted to the alpha engine of commingled vehicle Alpha flexibility
Separate accountCommingled productConsideration
May be higher due to lower average creditworthiness
Can rely on the expertise of the manager of the commingled fundfor alpha selection, beta management, contract negotiation, rebalancing and cash management
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IS PORTABLE ALPHA APPROPRIATE FOR YOURPORTFOLIO?
Although alpha can be transported to almost any assetclass or portfolio, there are two situations that areparticularly suited to a portable alpha application:(1) Portfolios with high allocations to index funds,lower-alpha enhanced index funds, or underperformingactive equity or fixed income managers. These portionsof the portfolio are prime candidates for replacementwith a portable alpha solution. (2) Liability driveninvestment (LDI) strategies where plan sponsors wouldprefer to increase their exposure to fixed income, but are
reluctant to because the expected fixed income returnsare well below required returns. Portable alpha can beused to help improve the performance of these lowexpected return asset classes without sacrificing thedesired benefits of lower volatility – detailed further inthe boxed text on LDI strategies, above.
Index fundsAn obvious use of portable alpha is to replace index fundallocations, which by definition offer little or no alpha.Presumably they are included in a portfolio to provide avery low-cost exposure to a desired beta. Portable alphaprovides a way to retain the beta exposure provided byan index fund as well as augment potential returns.
LIABILITY DRIVEN INVESTMENT (LDI) STRATEGIES
by Brandon HorwitzMorgan Stanley Investment Management
The increased desire for asset-liability matching and liabilitydriven investment strategies is a compelling argument forthe application of portable alpha in pension portfolios. Fixedrate and inflation-linked bonds are recognised as an idealasset class to match pension funds liabilities. The value ofthese bonds responds to changes in interest and inflationrates in the same way as the present value of pensionliabilities, thereby providing a good asset-liability match.
However, most pension funds are wary of increasingtheir allocation to these bonds. One reason is the desire toavoid locking into historical low yields and hence lowexpected returns from bonds. Another reason is thelimited opportunities to add alpha in high quality fixedrate bond markets and the comparatively much smallerinflation-linked bond markets. Differing inflationmeasures between countries and currency differencesfurther limit most pension fund investors to domesticbonds, an even smaller universe in which to add alpha.
Investors can address these traditional compromises bytransporting alpha onto a bond-style beta, potentiallyincreasing returns while at the same time matchingliabilities and reducing surplus risk. This bond-style betacan be tailored to reflect a particular pension fund'sliability profile using combinations of interest rate andinflations swaps which are closely matched to the fund’sfixed and inflation linked cash flows; their value willchange in tandem with changes in the value of the fund'sliabilities. These swaps fit naturally into a portable alphastrategy as they are unfunded instruments, meaning thatthe majority of the fund’s capital can then be invested inan appropriate alpha engine.
The same criteria for selecting an optimal alpha engineas described earlier clearly apply: the combined LDI/portable alpha solution requires a suitably risk controlledalpha engine targeting higher returns than those availablefrom bonds and cash. This creates a combined portfolioof assets which exhibit the liability-matching features ofa bond, and the return-generating features of an alphaengine – credibly matching liabilities while at the sametime providing a means to minimise the contributionsrequired to reduce pension deficits and/or increasebenefits to plan participants.
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Portable alpha provider checklist
Source: Morgan Stanley Alternative Investment Partners
Exhibit 5
What are the primary objectives, applications,benefits and risks associated with your programme?
What is your investment philosophy and process?
What is your experience managing portablealpha programmes?
Do you act as both alpha manager andbeta manager?
What is your primary alpha source and why?
What is the capacity of your strategy?
What is your track record of alpha generation?How does that compare to traditional managers?
What is involved in the beta overlay process?What value do you provide?How well have you tracked betas historically?
What are your fees per unit of alpha?How does that compare to traditional managers?
Do you earn a performance fee if your portable alpha programme does not beat the benchmark?
Key questions to ask
These should be clearly described andcomprehensively addressed.
Should be comprehensive, thorough, and combine sophisticated quantitative processes with extensive experience.
A lengthy track record is desirable – this is especially important with entry by many new and inexperienced providers.
Skill sets are different for each – make sure your provider has experience in both areas if they are managing both sides. Look for high quality alpha in the optimal zone of the portable alpha spectrum (target at least 300 to 400 basis points over LIBOR, low volatility, low embedded beta).
Seek strategies that can limit assets as appropriate to their investment strategy.
High information ratios – the ratio of alpha to tracking error –are desirable. High and sustained information ratios indicate the potential presence of skill vs. luck.
Check the sophistication of embedded beta tracking and monitoring, with low tracking error to benchmark betas.
Look for low fees per unit of alpha; be alert for betamasquerading as alpha.
No performance fee is earned if programme falls shortof the benchmark.
What you should seek in a response
Enhanced index fundsAs discussed, lower-alpha enhanced index funds canincrementally improve returns for a given beta, but theymay not meaningfully impact overall portfolio performance(as measured by returns, volatility, or asset-liability matchingfrom shifting allocations among asset classes). Also, as withany active manager, enhanced index funds mayunderperform their benchmark and their performance shouldbe closely monitored and evaluated. It may be advantageousto replace allocations to such funds with pre-packagedportable alpha products based on similar underlying betas.
Underperforming active equity or fixed incomemanagersMany traditional active equity or fixed income managersare good candidates for replacement by portable alpha,including managers who are:• generating little or no alpha and/or charging high
fees per unit of alpha;• taking very limited active risk (benchmark
hugging);• exhibiting high correlation to each other; and• exposed to undesired market factors.
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Why pay high fees for what is essentially betaexposure? Make certain your fees are being exchangedfor true benchmark outperformance.
CHECKLIST FOR YOUR PORTABLE ALPHA PROVIDER
Because of the complexity and cost involved in aportable alpha implementation, many investors areoutsourcing their portable alpha mandates to thirdparties who offer some or all of the services involved(e.g., optimal alpha engine selection and provision,embedded beta estimation and monitoring, overlayimplementation and management). If you decide to seekassistance from a portable alpha provider, considerasking the questions listed in Exhibit 5.
CONCLUSION
The marketplace is still in the early stages of what weexpect to be a massive shift by pension funds,endowments and foundations in the use of portablealpha to raise returns, reduce volatility, and/or achieveother objectives such as better asset-liability matching inLDI strategies. Investors are likely to increase their searchfor alpha, but the search is very access, skill- andlabour-intensive. It requires a great deal of experience,extensive investment and operations due diligence, andaccess to the best strategies and managers.
Portable alpha strategies can help improve portfolioperformance for institutional investors of all stripes. Bydissecting returns into their underlying components –
alpha and beta – and then seeking to optimise resultsfrom each component separately, investors maymeaningfully increase returns while maintaining levelsof market risk that are most appropriate to their objectives.
*The authors would like to thank Brandon Horwitz, Dominick Carlino and Scott Gregory for
their contributions to this article.
Notes:
1. 1 Fisher, I., 1930, The Theory of Interest (New York: Macmillan).
2. Modigliani, F. and Miller, M., 1958, “The Cost of Capital, Corporation Finance and the Theory
of Investment,” American Economic Review, vol. 48, no. 3, p. 261–297.
3. Markowitz, H., 1952, “Portfolio Selection,” The Journal of Finance, vol. 7, no. 1, p. 77–91.
Jack Coates Mark Baumgartner
Jack Coates, Ph.D., CFA is a Managing Director and theHead of the Portable Alpha Team, and
Mark Baumgartner, Ph.D., CFA is anExecutive Director and Portable Alpha Portfolio
Manager, of Morgan Stanley Alternative InvestmentPartners in West Conshohocken, PA.
For further information, pleasetelephone +1 (610) 940 5685 or
Disclaimer:Risk considerations: Alternative investments are speculative and involve a high degree of risk. Alternative investments are highly illiquid and may have higher fees than those charged by traditionalinvestments. A portable alpha strategy uses leverage and derivatives which can entail a high degree of risk.
This article does not purport to provide, and should not be construed as, investment advice to any person or entity in any manner. Furthermore, this article does not constitute an offer, or a solicitationof an offer, to buy or sell any security or instrument or to participate in any trading strategy. The forecasts and opinions in this piece are those of the authors only as of the time of this writing (whichare subject to change based on market, economic, or other conditions), are not necessarily those of Morgan Stanley AIP or Morgan Stanley Investment Management, may not actually come to pass, andshould not be construed as recommendations, but as illustrations of broader economic theses. All information contained within is based on past performance and is not intended to be indicative offuture results.
