Easy Money: The Temptation of Portable Alpha Strategies

Many pension funds were burned during the recent crash when this deceptively complex strategy failed miserably.


When David Deutsch encountered Westridge Capital Management in the mid-1990s, he was the executive director of a public pension fund in California’s central valley, home to avocados, oil rigs and Edwards Air Force Base. Westridge, founded by a couple of options market makers, was participating in a guaranteed investment contract fund in which Deutsch’s Kern County Employees’ Retirement Association had invested a chunk of its then-$1 billion in pension funds. In an aggressive marketing ploy, Santa Barbara–based Westridge approached the Bakersfield-based pension fund to suggest that it would do a lot better investing with Westridge directly rather than through the GIC.

The proposition was audacious. And yet to Deutsch, Westridge really seemed to have deciphered the Rosetta stone of investing. Its miracle product for ensuring good returns that were also rock steady and virtually risk-free went by a number of names but was ultimately dubbed “portable alpha.” Encouraged by Deutsch, Kern County eagerly embraced the strategy, over time committing $152 million to Westridge.

Although Kern was an early adopter of the strategy, it was hardly the only public fund to become smitten with portable alpha, which involves the systematic separation of beta, or index-like returns, from alpha, or active manager–generated returns above and beyond (one hoped) market gains. “Port Your Alpha and Eat It Too!” exclaimed a white paper from one respected consulting firm. Westridge boasted in its marketing material that it had achieved “excess returns EVERY MONTH” (emphasis Westridge’s). Portable alpha conferences sprang up like umbrella salesmen during a downpour in Times Square. Articles on portable alpha became a deluge of their own. As many as 50 a month were being published by 2006, estimated John Coates, head of Morgan Stanley & Co.’s portable alpha program, and Mark Baumgartner, the bank’s portable alpha portfolio manager, in an article of their own. Their firm surveyed the CIOs of 50 of the biggest public pension funds (total assets: $1 trillion) a few weeks before the fall 2008 credit market implosion and discovered that one quarter were using “some form” of portable alpha. At about the same time, an industry estimate put the total invested in portable alpha by institutions around the world at roughly $75 billion.

Today many public pension funds regard portable alpha as the toxic waste of portfolio strategies (and David Deutsch is unemployed). Vastly overhyped, portable alpha has suffered a series of dramatic reversals in recent years. Not least was the strategy’s dismal overall performance throughout the credit and financial crisis, in no small measure because of a reliance on quantitative investing techniques and leverage.

The stock market correction in late-summer 2007 caused many quant strategies to stumble badly. With nary a pause the 2008 credit and banking crisis hit, and markets imploded. Correlations among ostensibly divergent asset classes went to 1, and many public pension funds found that rather than protecting their portfolios against losses, as promised, portable alpha made matters worse. Some portable alpha portfolios plummeted by 30 percent or more. And some investors found they had to cough up cash to cover portable alpha derivatives losses.

Collective numbers are hard to come by, because the portable alpha format accommodates such a variety of investment approaches. But anecdotal evidence indicates that many public funds that committed substantial capital to portable alpha sustained disproportionate losses and have now sworn off the strategy with the fervor of ex-addicts.


Kern County, whose assets today amount to $2.65 billion, may soon be among them. In fiscal 2009 its investment portfolio lost $739 million, and the portable alpha strategy was an outsize contributor to that decline. Kern is currently reviewing the fate of its portable alpha managers.

What went wrong? Is portable alpha truly to blame? Or is it possible that a perfectly valid, rather ingenious portfolio management approach was misunderstood and hence misused? Should a Committee to Save Portable Alpha be formed, if only to preserve a legitimate strategy for a more circumscribed function? “People ruined portable alpha,” declares one disgusted hedge fund manager who still believes in the concept. And he may just have a point.

“You have to take risk to earn return, and you want to take risks in the most efficient way you can,” notes Alistair Lowe, CIO of multi-asset-class solutions and currency for Boston money manager State Street Global Advisors. “We think the concept of portable alpha still makes sense.” Many investors, however, either did not understand the risks or misapplied the strategy, he says.

If done right, portable alpha does not have to be high-risk, points out former Goldman, Sachs & Co. managing director Daniel Jick, co-founder of Boston asset manager HighVista Strategies. “Portable alpha does not always involve significant leverage,” he says, while acknowledging that many investors did heighten leverage by in effect investing every dollar twice. “Some people doubled-dipped in their application of portable alpha,” he explains. “If people don’t appreciate the level of risk, that can feel like a little bit of a free lunch.”

Leverage is both the boon and the bane of portable alpha. Invented in the mid-1980s, the strategy had a genuine appeal, though it was slow to catch on by the standards of most investment fads. Greatly oversimplified, portable alpha involves splitting beta — the marketlike returns — from alpha, the above-market returns achieved through active (often very active) management. Moreover — and this is the crux of it — the strategy liberally uses leverage, the steroids of investing. Rather than tie up a wad of money in a passive index fund to obtain the beta component (confusingly labeled the “alpha overlay”), portable alpha instead relies on derivatives — typically, futures and swaps — to mimic the market, on margin in effect. The genius of this is that it frees up capital for the all-out pursuit of alpha. Still, a significant cash reserve has to be set aside to cover derivatives contracts when they come due.

As for the alpha portion, the basic idea is to swing for the fences (never forgetting risk management, naturally). Rather than having to concern themselves with finely calibrated allocations to this or that asset class, public fund CIOs could hand over a bundle of cash to a portable alpha manager to distribute to, usually, hedge funds or funds of hedge funds, with one simple injunction: “Beat the market, any way you know how.” In theory this unleashed portfolio managers from the constraints holding back their performance. The strategy also got around an awkward problem: the fact that few managers ever beat their benchmarks in high-traffic areas like large-capitalization growth stocks. (A portable alpha program was also a backdoor way for public funds to invest in hedge funds without the hassle of having to secure trustee approval.)

As portable alpha evolved, quantitative investing emerged as its chief investment style. Popular with hedge funds, this trendy technique puts powerful computers and sophisticated mathematical tools to work combing through vast market databases to detect patterns that, in theory, reveal just which securities to trade for optimum gains. As it happened, many of the most popular portable alpha managers, including Barclays Global Advisors and State Street, were largely quant-driven. As Alan Dorsey, head of investment strategy and risk at Neuberger Berman Group, notes, portable alpha investors liked the strategy because they considered it more rigorously back-tested than other methods, thanks to its wealth of data.

It’s easy to see why David Deutsch found portable alpha appealing for Kern County. And the strategy’s solid results seemed to underscore his astuteness in advocating Westridge. Indeed, Deutsch’s success with portable alpha didn’t hurt his prospects when he was recruited in 2003 to become CIO of the then–$5 billion San Diego County Employees Retirement Association, which had a portable alpha program and already employed Westridge as a manager.

By April 2007, Westridge had amassed $3 billion, and for what appeared to be sound reasons. Its annualized return since April 1996 — the year Kern County began investing directly with it — was 10.93 percent; its cumulative gain for the decade, 210 percent. What’s more, Westridge had never reported a down month, much less a down quarter. Even in the summer of 2007, when most quants tripped, Westridge’s portable alpha portfolio kept its footing. The firm explained that its index arbitrage strategy (using Standard & Poor’s 500 options) allowed it “to consistently outperform the underlying index with a risk profile virtually identical to the index.” What could be better!

Indeed, in March 2008, as investors’ anxiety level rose, pension consulting firm Wilshire Associates recommended that the Iowa Public Employees’ Retirement System up its allocation to Westridge in response to the underperformance of other managers. And in September 2008, amid the darkest days of the credit crunch, Wilshire recommended that the $45.5 billion Commonwealth of Pennsylvania Public School Employees’ Retirement System invest $1 billion with Westridge — which it agreed to do but never actually did.

To some prospective investors and investment consultants, the metronomic consistency of Westridge’s results raised a red flag. However, Deutsch, who spent three years in medical school before embarking on a career in finance and eventually earning an MBA at the University of Texas, says he performed extensive due diligence on the firm, and over the years he found no cause for concern. Westridge, after all, had been around since 1983 and boasted public fund clients like Iowa, North Dakota and Sacramento.

By 2008, however, San Diego was starting to have suspicions. In October of that year, one of its consultants, Albourne Partners, visited Greenwich, Connecticut–based WG Trading, the Westridge affiliate that operated the “alpha engine” of the firm’s portable alpha strategy. Two of Westridge’s founders, Paul Greenwood and Stephen Walsh, ran WG Trading, and the Albourne emissaries “found Greenwood to be uncooperative and evasive,” according to San Diego’s records. Unable to obtain the desired transparency, Albourne recommended termination; San Diego initiated the redemption process on December 31.

Nevertheless, it came as a shock to Deutsch and other Westridge investors when barely one month later the Federal Bureau of Investigation announced that it had arrested Greenwood and Walsh and charged them with conspiracy and securities and wire fraud. The FBI alleges that the pair “misappropriated the majority of the investor funds” — roughly $668 million — that had been invested through WG Trading. Allegedly, Greenwood used the money to buy, among other things, horses and expensive collectibles, and Walsh, according to the FBI, made “cash payments to his ex-wife.” Both men have pleaded not guilty to the criminal charges.

Westridge’s third partner, James Carder, who ran the beta portion of the strategy out of Santa Barbara, is not a party to any of the criminal proceedings. Sources close to him say he swears that he had no idea what his partners back in Connecticut were allegedly doing.

One month after the Westridge scandal broke, Deutsch resigned as CIO of San Diego. The pension fund doesn’t know how much of the $78 million it had with Westridge can be recovered. The county hasn’t done much better on its other portable alpha investments. For fiscal 2009, San Diego County reported losses of $276 million on its alpha engine and S&P swaps.

Not surprisingly, San Diego has had it with portable alpha. The strategy was off-puttingly complex, and the fund lost money on it not only in the late summer of ’07 (when the quant funds blew up) and the fall of ’08 (when Lehman Brothers Holdings collapsed), but also in the autumn of ’06. That is when one of San Diego’s hedge fund managers, Amaranth Investment Advisors, was forced to shut after it lost more than $6 billion, mostly from betting wrong on natural gas futures. San Diego is unwinding its portable alpha program with all deliberate speed.

Deutsch sees that as self-defeating. Although he grants that if he had it to do all over again, he would try to reduce tracking error, and thus risk, in the portable alpha programs he oversaw, he remains a staunch believer in the strategy. By bailing out, he says, plans are simply locking in losses. “It is a mistake to pull these programs down now,” he insists. “The risks associated with a large-cap S&P portable alpha structure are no different from the risks associated with a traditional S&P portfolio — they have the same equity risk.” But with the former, Deutsch notes, you are adding an alpha source, which means that “in theory you are much better off.” Still, he concedes that in practice “things can be more difficult.”

Some pension consultants would likewise argue that public pension funds should not abandon portable alpha programs just because the strategy has had a few rocky years. As Neuberger Berman’s Dorsey points out, investors that hung in with the strategy through the 2009 rebound stood a better chance of recouping their 2008 losses. State Street’s Lowe confirms that “for those investors that stuck with it and planned their liquidity calls well, they have had a strong rebound in 2009 in both alpha and beta.” He says State Street still has clients doing portable alpha.

Nonetheless, although it may not be correct to label portable alpha snake oil — unlike some past investment nostrums, such as portfolio insurance — it is far from the all-purpose panacea it was billed as by purveyors of portable alpha (and not a few consultants). “Clearly, the actual risk was higher than the anticipated risk,” says Keith Black, pension consultant with Chicago’s Ennis, Knupp & Associates. His firm was among the consultancies that did not promote portable alpha. One upshot is that Ennis Knupp has been winning mandates from public funds fed up with portable alpha and looking to purge it from their portfolios.

Other prominent consulting firms did champion the strategy, including not only Wilshire but also Cambridge, Massachusetts–based NEPC; Memphis-based Consulting Services Group; and Norwalk, Connecticut–based Rocaton Investment Advisors. Some consultants now concede privately that they might have been a touch too exuberant in touting the strategy. In the words of one: “People underestimated the equity beta that was in the alpha portion [that is, the diversification benefit wasn’t what it was cracked up to be]. I don’t think it is a strategy that should never be used, but it should be used more sparingly.”

Other advisers, wary of portable alpha’s recourse to leverage, remain skeptics. Along with Ennis Knupp, the doubters include Angeles Investment Advisors in Los Angeles and Aksia in New York. “The idea has merits,” allows Angeles CIO Michael Rosen. “The challenge is in its execution. Success is predicated on delivering alpha, and that never has been an easy thing to do.” His advice: “You have to go into any new thing, particularly when there is less historical data to look at, thinking about what the risks are. How does something that sounds good look when it goes wrong?”

Portable alpha stirred controversy from the start. Yet that didn’t deter many public pension funds from rushing to embrace what looked to be a groundbreaking investing method that promised steady and practically riskless returns. In its recurring surveys of institutional investors’ approach to “alternative” investments, Russell Investments Group didn’t bother to mention portable alpha at all in 2003. But in 2006 the Tacoma, Washington–based consulting and money management firm reported that 13 percent of North American institutional investors had made portable alpha allocations and that a further 25 percent were considering doing so. Two years later, right before the crash, Russell says 22 percent were using the strategy, and an additional 45 percent were mulling it over.

The portable alpha phenomenon took on all the earmarks of a fad, but that was not something altogether new in pension land. In a familiar pattern public funds have opted for ostensibly high-yielding but also highly complex quantitative strategies during a bull market, only to abandon them after the market corrects and their hotshot portfolio managers run into performance problems, or worse. Portfolio insurance is one glaring example — but so, arguably, are market-neutral, enhanced indexing and alpha-extension products, often known as 130/30 strategies (which go long and short simultaneously).

Often the intellectual underpinnings of any given strategy are perfectly sound but poorly understood, and, as a result, the strategy is misapplied and mismanaged. That is precisely what happened with portable alpha in many cases.

“If you invest in portable alpha, you need to understand the underlying strategy and you need to understand the skills of the underlying mangers in those strategies,” cautions Ennis Knupp’s Black. “It is important that you truly understand the sources of return and the sources of risk.” A great danger, he notes, is investors’ falling “in love with the returns” and shortcutting due diligence.

In fairness it is not so easy to conduct due diligence with respect to portable alpha. The strategy thrives on complexity. One reason Westridge was able to get away with its alleged deception is that its quant approach came across to many investors as impenetrable. “The fraud issue will remain regardless of whether it is portable alpha or absolute-return strategies,” points out Timothy Barrett, CIO of the San Bernardino County Employees Retirement Association. “Avoiding fraud is really a function of high-end due diligence.”

Although some investors in portable alpha understood what they were doing, others hadn’t a clue. For instance, several seemingly did not grasp the cash management obligations that are an integral part of the beta, or alpha overlay, function. Indeed, some apparently did not fully comprehend that investing in a derivatives overlay entailed substantial leverage. And the greater the leverage, the less cash on hand to meet derivatives commitments in a falling market. “Many investors failed to realize that by using swaps they were leveraging up their portfolio, and that the markets can work against you,” explains Daniel Celeghin, a partner with Darien, Connecticut, investment management and consulting firm Casey, Quirk & Associates.

Some critics are adamant today that public pension funds should never have been introduced to portable alpha in the first place. “The industry has become all about product creation and fees,” laments Thomas Flannigan, former CIO of the California State Teachers Retirement System, the country’s second-largest pension plan, and currently a board member of the Orange County Employees Retirement System. (CalSTRS has never used portable alpha.) Flannigan is critical of consultants who recommend high-fee, high-leverage investment approaches like portable alpha, and of the portfolio managers who implement them. In their race to reach their actuarial assumptions, Flannigan argues, pension investors took excessive risks. They have “too much money chasing ideas,” he says, “particularly with managers that really don’t know what they are doing, in hopes of making up that lost ground.” He believes that investors should stick to low-fee products, such as plain-vanilla bond portfolios and indexing.

However, others see healthier forces at work in portable alpha’s travails. “Over time there is a weaning process,” says one longtime quantitative manager at a major investment firm. Managers make mistakes, but under pressure good ones rise to the top, poor ones fail and frauds are uncovered; this is how the investment industry evolves.

Some public pension plans did handle the credit crisis adroitly within their portable alpha programs. The San Bernardino fund was about as well prepared as any fund could have been.

The sprawling county in California’s Inland Empire had implemented its portable alpha strategy in 2003, and longtime CIO Barrett avows, “We believe we understood the risks.” San Bernardino manages the beta and alpha components separately, as Barrett feels this permits more control — which would prove crucial when the credit crisis hit. (This structure also meant, fortuitously, that when Westridge came calling, San Bernardino dismissed the firm out of hand because it offered only a bundled product.)

In the summer of tumultuous 2008, almost one third of San Bernardino’s nearly $5 billion in assets were allocated to its portable alpha pool. On the beta side, a notional $632 million was devoted to an alpha equity overlay and a notional $707 million to an alpha fixed-income overlay, both made up of swaps and some futures.

Barrett, who has always paid close heed to cash management — typically keeping at least 10 percent of his portfolio in cash — recalls that during the crash “that liquidity buffer started to evaporate.” So in October 2008, not long after the convulsive bankruptcy of Lehman, Barrett asked his board to let him reduce San Bernardino’s notional alpha equity overlay exposure by $550 million.

That turned out to be prudent. For many portable alpha programs, the greatest damage from the crash came from a combination of poor liquidity management and equity overlay losses. By systematically cutting its derivatives exposure early on, San Bernardino was able to slash its leverage and, as a consequence, did not have to liquidate other holdings to cover beta losses. Moreover, the fund had cash on hand to backstop other temporarily troubled investments. “We had that money to fight other fires,” notes James Perry, San Bernadino’s investment officer for public markets.

Other public funds were slammed much harder. San Diego waited until November to take off its alpha equity overlay and wound up having to pay hundreds of millions of dollars to backstop its beta losses.

State Street had briefed its own clients about what might happen in a precipitous market downturn, Lowe says, but other investors “were shocked that the market could go down and alpha could go down at the same time.” He adds that “cash was a problem for some [portable alpha] investors. Some didn’t understand the liquidity issues.”

As the crash intensified, the quant-driven alpha engines of most portable alpha programs sputtered or stalled amid a comprehensive market breakdown. Thus they could do nothing to pull beta portfolios back from the brink. Compounding the distress for many funds was the discovery that their portable alpha portfolios were not as uncorrelated with their other assets as they had imagined.

This was especially true of alpha overlay programs that had invested in funds of hedge funds. “Many of the funds of hedge funds used in portable alpha programs had more beta in their returns than we like,” explains Ennis Knupp’s Black. Yet another largely unforeseen problem for some portable alpha investors was not being able to access the cash they did have, because the money markets froze solid in the immediate aftermath of Lehman’s demise.

So what becomes of portable alpha now? Pacific Investment Management Co., which arguably introduced the first version of the strategy in the mid-1980s under the StocksPLUS name, ought to have a pretty good take on portable alpha’s prospects. Before the crash the firm was worried about the way portable alpha was being misapplied. “There was so much hype in the marketplace surrounding the strategy,” recalls Sabrina Callin, managing director and product manager of Pimco’s portable alpha strategies. “People were implementing different approaches and taking on a lot of risk, without always understanding the different components of risk they were taking on.”

In fact, Callin and her colleagues felt compelled to write a book to clarify matters (and perhaps spark a few sales): Portable Alpha Theory and Practice (John Wiley & Sons, 2008). “The underlying concept behind what became known as portable alpha is one that makes a great deal of sense, so long as investors understand the risk and the liquidity is dealt with appropriately,” Callin says.

Pimco has seen net inflows into its portable alpha strategies in 2009, and it may well be that long-duration products like the firm’s StocksPLUS Long Duration will carry the torch for portable alpha as pension funds are forced to more closely match assets to liabilities.

San Bernardino is one public fund that is unhesitatingly sticking with portable alpha. As Barrett points out about the massive market upheaveal that led so many public funds to become disenchanted with the strategy, “Portable alpha depends on the fact that correlations don’t all go to 1, and there is no strategy outside of cash and government bonds that, in the heat of a crisis like that, will hold up exceptionally.”

San Bernardino’s alpha pool lost some 30 percent in 2008, chiefly because of mark-to-market losses in leveraged loans. But by the end of 2009, says investment officer Perry, the portable alpha portfolio was up 26 percent for the year and had made back most of its losses.

Others remain tepid about portable alpha. “It has become something with a very, very narrow application,” maintains Casey Quirk’s Celeghin. If the strategy is used anywhere, he says, it will be in fixed-income portfolios, as funds move toward a greater allocation to bonds to better match assets and liabilities. However, HighVista’s Jick warns that dangers exist in applying leverage to what has typically been a low-risk sector of an investment portfolio.

In any case, separating alpha and beta return streams still has validity. Mark Carhart, who retired as head of quantitative strategies at Goldman Sachs Asset Management last year, thinks managers should separate investment returns into beta and “true alpha” and price them accordingly. “All managers have their embedded beta,” he says. But investors should not pay high fees for beta, Carhart asserts.

Portable alpha might be in disrepute among many public funds, but what the strategy represented from the outset — a loosening of portfolio manager restrictions, the use of leverage to enhance returns and reliance on quantitative investing techniques — is not about to slink away from the scene. Paradoxically, portable alpha’s setbacks might encourage public funds that invested in hedge funds indirectly to now invest in them directly. And after a hiatus they will surely explore other leveraged, quantitative approaches to investing. But they had better read the instructions carefully first.