With investors looking to separate their alpha and beta bets, portable alpha strategies are becoming a favorite of the pension crowd -- and money managers are trying to develop new products to meet the growing demand.
In a portable alpha strategy, an investor makes separate investments in alpha and beta, using a combination of passive approaches -- market exposure from index funds, futures or swaps -- and high-alpha products like hedge funds. A pension fund might get beta exposure on $100 million of equities, for example, by using $5 million to buy swaps or futures that deliver the gain or loss on an equity portfolio several times that amount. Then it would use the remaining $95 million of plan assets to invest in, say, a fund of hedge funds that aims to deliver pure alpha. And it must be pure: For alpha to be completely separate from beta, as the strategy demands, the hedge fund manager must carry no beta exposure at all.
Traditionally, institutional investors have custom-designed their own portable alpha strategies, usually with the help of a specialist consultant or money manager. The plan sponsor establishes the market exposure through index futures or swaps, maintains the contracts and replaces them as they expire. The sponsor also selects alpha that complements the returns of the plan's other assets, then hires and monitors the best managers it can find, judging them on the relative volatility of their returns as well as on how the managers correlate both to their markets and to each other. The program is structured to dovetail with the existing portfolio.
Some money managers, including Putnam Investments, now plan to prepackage their portable alpha strategies into conventional commingled funds. Here the money manager creates the beta, supplies the alpha (or outsources the job to another asset manager) and handles all the investing mechanics. Asset managers hope that these off-the-shelf portable alpha strategies will appeal to pension plans that are either too small to justify the costs of a custom-made program or lack the expertise to confidently deploy the strategy.
David Saunders, a principal at $3.5 billion fund-of-hedge-funds manager K2 Advisors in Stamford, Connecticut, reports that his firm is working on two prepackaged portable alpha offerings, one with traditional hedge fund alphas, and one that uses active currency management to add value.
"You've got to expect this sort of evolution," notes David Katz, a partner at Rocaton Investment Advisors, a Norwalk, Connecticutbased consulting firm. "The big institutions have lots of clients that want to invest in these strategies, and if they don't build these products, the clients will go to the specialist firms."
Michael Manning, president of Cambridge, Massachusettsbased New England Pension Consultants, reports that his firm is working with portable alpha managers (he declines to offer names) to transform custom-made strategies into sponsor-friendly commingled vehicles.
No one really knows how much is invested in portable alpha strategies. It's difficult even to define the market, because much investing occurs through futures positions. Also, some sponsors manage programs in-house, and the amount of those investments often remains unknown. But experts estimate that the market totals at least $125 billion.
One of the oldest portable alpha offerings is Pacific Investment Management Co.'s 19-year-old StocksPLUS, a $30 billion controlled-risk enhanced index strategy that adds an alpha component drawn from the short-term bond market to beta provided by Standard & Poor's 500 index futures. Since the launch of StocksPLUS, Newport Beach, Californiabased Pimco has introduced several offshoot strategies with betas in commodities and real estate; they've reeled in an additional $10 billion in assets.
Bridgewater Associates of Westport, Connecticut, manages $25 billion in portable alpha strategies. Other portable alpha managers include Pasadena, Californiabased Western Asset Management Co. and New Yorkbased BlackRock, which each offer products similar to Pimco's StocksPLUS, with assets of $5 billion and $2 billion, respectively. Benchmark Plus Partners of Tacoma, Washington, manages a $1.3 billion strategy drawing alpha from a 30-manager fund of hedge funds.
Most sponsors began to think about portable alpha only after the tech stock bubble burst. After all, in the late 1990s pure beta was plentiful, with the S&P 500 returning an average annual 26 percent from January 1, 1996, to December 31, 1999. But with ten-year Treasury bonds now yielding less than 4 percent and U.S. equities delivering only tepid returns, investors have a much stronger interest in alpha, notes Michael Purvis, head of risk management at New Yorkbased Blackstone Alternative Asset Management. Says Purvis, "When bonds are yielding 4.5 percent and stocks are not much better, and plans need 7 or 8 percent, there's an increased interest in alpha."
Pimco's StocksPLUS, which has pulled in more assets than any of its rivals, differs in several respects from its competition. First, rather than seek the several hundred basis points that more aggressive strategies insist on, StocksPLUS delivers an enhanced equity index return -- beating the S&P 500 by 90 and 92 basis points, respectively, for the five- and ten-year periods ended March 2005. Second, StocksPLUS handles all the trading and settlement gymnastics the strategy demands; for many of its rivals, those jobs are left to the sponsor. "People say beta should be free, but there are a lot of important details," notes Sabrina Callin, product manager of StocksPLUS.
Brought to market in 1989, Bridgewater's portable alpha product is more aggressive than StocksPLUS, reaching for greater risk and return and diversifying its sources of alpha. The firm has since fashioned its product, called Pure Alpha, into a standardized offering. Bridgewater's clients choose from 26 different benchmarks for their account's market return and can specify the level of tracking error -- or, as president Raymond Dalio puts it, "how spicy they want the alpha." The firm's pure alpha pool is managed in-house and draws from 77 markets or market spreads around the world. Dalio reports that the strategy has realized an impressive information ratio -- alpha divided by tracking error, a key measure of performance -- of 1.30 annualized since 1989.
New to the portable alpha game, Boston-based Putnam has a product on the drawing board that would incorporate alpha from nine in-house strategies developed for the firm's global tactical asset allocation accounts. "We plan to offer a portable alpha product that could substitute for any traditional large-cap equity product," notes Jeffrey Knight, chief investment officer for the firm's global asset allocation group. Like StocksPLUS, the strategy would be delivered as a prepackaged fund, perhaps as soon as Labor Day.
"We will make the specific portfolio structure of futures and swaps our problem rather than the client's," Knight explains.
Although a standardized account with a variety of sources of alpha has definite appeal for consultants and money managers, some would argue that alpha is too valuable to be sold off the rack. "Some of our clients want portable alpha with a narrow set of strategies on the equity part of the portfolio, and others want broader strategies on fixed income or their liability stream," observes Kurt Winkelman, head of global investment strategies at Goldman Sachs Asset Management in New York. "It's hard to see a one-size-fits-all solution."
Relying on one manager to produce all of a strategy's alpha can be constraining as well, notes Harindra de Silva, president of Analytic Investors, a Los Angelesbased quantitative money manager. "Judgment is what produces alpha," says de Silva, "and if you go to just one manager for all the alpha strategies, you no longer have diversification of judgment." His firm does not offer a prepackaged product but supplies individual sources of alpha that are packaged by specialist firms like Clifton Group of Minneapolis.
But Putnam's Knight makes the case for a one-source supplier of alpha. "You may not get the best in class in every strategy, "he says, "but you're getting a more manageable and coordinated product."