Giovanni Legorano looks at how pension funds' approach to portable alpha has had to evolve
Portable alpha strategies are among several approaches through which pension funds around the world have been trying to meet increasingly challenging target returns, under the pressure of longevity issues.
Market turbulence has on the one hand prompted investment caution. However, on the other hand the need for returns has kept active strategies high on pension funds’ agenda. This quest for returns has, according to many industry figures, kept interest in portable alpha approaches high, while others noted some of these strategies’ drawbacks pushed pension funds towards different alpha generating techniques.
American Century Investments vice president Peter Brackett explained the central tenet to portable alpha is that beta is “cheap and easily accessible”, while alpha is “scarce and typically is not where funds want it to be”.
He said: “For a pension fund that has a strategic asset allocation spread among a number of asset classes it may not be the case that the alpha they require is actually resident in any of those asset classes.”
In terms of what this approach is, the definitions available in the market vary, but they are all based on the separation of alpha and beta in an investment decision, through various and complex ways.
Brackett said: “Pension funds are looking at their liabilities and determining what they need to obtain by way of market returns, mainly through asset liabilities modelling. Once a strategic asset allocation is determined, the associated returns can be obtained very cheaply by going to the markets and passively obtaining that asset allocation or obtaining it through swaps and futures. The portable alpha technique can then be applied by looking at the alpha source, taking away the embedded beta and bringing alpha on top of the strategic asset allocation obtained through passive means.”
Pimco managing director and product manager Sabrina Callin said there were a broad set of possibilities for the use of portable alpha. She said: “It is used very extensively to provide incremental excess return over and above the equity market return through a combination of equities, derivatives – primarily futures – and actively managed fixed income collateral.”
She added other common examples of portable alpha strategies being used are based on a similar design, with equities – plus futures or swaps – collateralised by certain types of absolute return strategies. A third common one would be based on commodity derivatives, where the returns are “commodity plus returns”.
A year after the collapse of Lehman Brothers – indicated by most as the turning point of the financial crisis – pension funds are still perceived as being extremely cautious of who they are dealing with, especially from a counterparty risk perspective.
Portable alpha strategies imply the use of derivative contracts, which expose schemes to the risk of the counterparty default, as Lehman’s bankruptcy showed.
However, industry figures mostly agreed some forms of portable alpha strategies continued to be used during the year.
Redington founder and co-chief executive Robert Gardner said: “Portable alpha means different things to different pension funds, depending on what they are porting. Prior to the credit crunch, strategies based on buying, for example, S&P equity exposure passively and overlaying Japanese equities alpha were gaining popularity.
“Right now, I think the concept applies more to taking risk in one asset class and then overlaying derivatives to change the nature of that risk profile.”
Callin noted portable alpha strategies have been increasingly popular with the pension fund community over the last year.
She explained: “Not surprisingly and consistently with investment approaches and throughout the market crisis, the basic concept of enhancing returns through a combination of derivatives backed by relatively safe complementary collateral investment portfolio is something investors believe still makes sense.”
However, she added some of these approaches suffered during last year. “Strategies that coupled, as an example, equity markets derivatives with collateral alpha strategies, which also carried significant amount of equity market risk, managed the crisis on the downside in terms of derivatives losing value to a significant extent at the same time that the underlying collateral lost a lot of value.”
In particular, strategies employing hedge funds ran the risks to suffer the pressures this type of asset class experienced, both on the performance and investors’ redemptions side.
Hewitt Global Investment Practice consultant Peter Hill said those challenges affected portable alpha strategies in a relatively limited way. He said: “The use of these strategies has not been impacted significantly by the redemption pressures and other challenges hedge funds had during the crisis.
“Many hedge funds experienced tremendous redemption pressures that made it even more difficult to protect capital. On the other hand, there are managers and strategies that have done very well and represented an excellent diversification tool for pension funds through 2008.”
In the fixed income space, Hewitt Global Investment Practice consultant Lennox Hartman said the situation was much more straightforward. He said: “Pension funds still believe in the concept of portable alpha over the long term in the fixed income space and, in general, investors are still confident in LIBOR plus strategies.”
However, Brackett believed portable alpha strategies have been a much discussed, but little implemented process. He said: “There are not that many examples around there of schemes that have used portable alpha and one main reason being the complexities associated with it.”
He explained: “If you are a pension scheme who wants to implement portable alpha yourself, you do need a high level of sophistication and resources. From a board of trustee’s perspective, you need fairly good governance to execute such a strategy. You need to find managers you think can deliver sustainable alpha, access the derivatives market to be able to build on the embedded beta and need to execute a strategy to get broad market exposure. In order to take away the embedded beta, you also need to be assessing what that beta is and monitor it through time, as beta fluctuates within the long only space.”
Pros and cons
If complexity is one of the main drawbacks hampering the adoption of such an investment process, Brackett said among the growth in strategies which can be considered within the portable alpha space, liability driven investment (LDI) strategies gained a lot of ground.
He explained: “If a pension fund creates a portfolio that mimics the duration of its liabilities through bonds and swaps, then it would be very attractive to port on the top of that alpha sources which are largely uncorrelated to the liabilities and create a growth portfolio in excess of its swaps that would generate the potential to cover liabilities less visible to the fund.”
More generally, as with all active strategies experts warn about the ability of managers to generate alpha.
Gardner said: “Schemes really need to believe that the manager which they are porting the alpha from is really generating alpha and assess how much it is worth paying for. This can make sense when using a manger who is investing in assets that are not a part of a fund’s strategic asset allocation. Post credit crunch, however, we are talking about portable beta or combining betas to create new profiles.”
Pimco’s Callin emphasised the portable alpha investment application allow pension funds to capitalise on their longer term investment horizon to a much greater degree than traditional equity investment would.
She said: “Investors are able to benefit from the ability to obtain equity market exposure at a very low interest rate cost, which is one of the benefits of having a long term horizon. If you think about the idea of allocating to the equity market by using derivatives, what in effect you are doing is obtaining your asset exposure up front but deferring payment.”
Callin also said another way to capitalise on a long-term horizon would be by taking some incremental risk, gaining exposure to very high quality, low risk fixed income portfolio and capturing some “attractive incremental yield” holding those securities as a long term investor.
Several industry figures also emphasised the ability of these strategies to provide diversification benefits to a plan’s portfolio. However, they also warned about the liquidity risk it might be associated with them.
Callin said: “Liquidity is a crucial component to a successful portable alpha approach, because while you are gaining asset exposure up front and not paying for it, if that asset value declines because of the way derivatives work investors will have to pay for the market decline. In other words, the collateral cost. Therefore you need to have that liquidity in your underlying strategy, in order to meet those margin calls – cash calls – when the market declines. We believe that appropriate liquidity management is a fundamental criterion of any portable alpha approach.”
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