Money Management (II): Divide and conquer

Institutional investors are talking a lot about alpha these days, but they're not talking just about hedge funds. Recently, a tactic known as portable alpha has caught on with the pension crowd.

Using this strategy, an investor separates his beta and alpha bets. Typically, an investor will take a small portion of the overall equity portfolio and earmark it for souped-up index funds -- basic passive strategies that have been leveraged with swaps and derivatives. That's the beta exposure. The remainder is allocated to hedge fund managers, who are charged with delivering alpha.

Some major funds are employing the strategy. The $25 billion-in-assets Pennsylvania State Employees' Retirement System and the defined benefit plans of Verizon ($40 billion), International Paper Co. ($6.5 billion) and Cooper Industries ($600 million) all use portable alpha for some portion of their portfolios. BP America's fund ($5 billion) has used portable alpha techniques for the better part of a decade. Although the strategy is mostly a U.S. phenomenon, several large European pension funds have recently signed on. Among them: the $133 billion Norwegian Government Petroleum Fund and the Netherlands' $194 billion Stichting Pensioenfonds ABP.

In June, as part of a $6 billion allocation to ten enhanced equity index asset firms, the California Public Employees' Retirement System, the world's largest plan sponsor, with $157 billion in assets, decided to hire four fixed-income managers -- Atlantic Asset Management, Pacific Investment Management Co., Smith Breeden Associates and Western Asset Management Co. -- that all use portable alpha strategies. CalPERS defines the allocation as enhanced equity because these managers use long positions in either Standard & Poor's 500 futures or swaps to gain large-cap market exposure and then actively manage short-duration bond portfolios to gain alpha.

"It is a way to enhance the return of the overall fund by porting alpha from one asset class over to another," says Christie Wood, a senior investment officer at CalPERS. "To the extent you have things in there that behave differently from one another, your portfolio benefits dramatically."

"The next wave is coming for this type of strategy," says Robert Hunkeler, director of investments at International Paper's pension fund, which allocated $320 million, or 20 percent, of its equity portfolio to a portable alpha strategy in June 2003. "It is going to be one that gets a lot of interest and ultimately a lot of funds directed that way." Last month the $11.8 billion San Francisco City & County Employees' Retirement System announced that it is considering implementing a portable alpha strategy using money managers already on its roster.

Here's how a plan sponsor might employ the strategy: Consider a $200 million portfolio with a 50-50 allocation in large-cap stocks and U.S. bonds. For the equity portion the fund could invest $100 million in active large-cap managers in an attempt to get alpha. But the alpha doesn't have to come from the large-cap arena. Instead, the fund could purchase S&P 500 futures to get its required allocation of 50 percent in large-cap stocks, with only a tiny amount of collateral needed to get the required large-cap beta exposure. To get beta exposure on the $100 million, the pension fund could use 5 percent of assets, or $5 million, to buy swaps or futures that deliver the gain or loss on an equity portfolio several times that amount. The remaining $95 million would be invested in one or more hedge fund strategies, the sources of alpha. A key assumption here: These alpha managers have no beta exposure of their own. In essence, the alpha is separated from the beta.

"Just because you are investing in the U.S. stock market doesn't mean you have to search for alpha in the U.S. stock market," says Robin Pellish, a partner at Rocaton Investment Advisors, an investment consulting firm in Norwalk, Connecticut. "You can search for alpha elsewhere."

Typically, funds put up even less than 5 percent -- often just 2 or 3 percent -- and then invest the rest in alpha managers. The $5.1 billion San Diego County Employees' Retirement Association uses a portable alpha strategy for its large-cap domestic equity allocation, about 20 percent of its assets. It uses eight alpha managers, including a fixed-income manager and hedge funds that employ strategies such as convertible bond arbitrage, market-neutral, equity long-short and S&P index arbitrage. The result: The plan beat the S&P 500 by almost 2 percentage points in 2003.

"We can use a whole variety of sources to add to large-cap domestic performance even if those strategies and vehicles are invested in international positions or convertible instruments," says David Deutsch, chief investment officer at SDCERA. "But you can't do that until you decompose beta from alpha. Otherwise you are constrained to exposure in the asset class."

For SDCERA and other investors, the alpha generated from other sources in the portfolio would then be ported onto, or combined with, the beta component. The industry jargon is not meant to be literal: The alpha is ported only as portfolio returns on paper -- no money actually moves.

With last year's resurgent equity markets petering out in 2004 (the S&P 500 index was down 1.5 percent through late August), plan sponsors are searching for excess return wherever they can find it. "Plan sponsors are all looking at the same crystal ball, which is rather cloudy right now," says International Paper's Hunkeler. "We have gotten wonderful returns from beta exposure over the last 20 years. But nobody is expecting very high returns into the near future, so they are looking for ways they can enhance what little return they expect to get."

Of course, there's no guarantee that a hedge fund manager can beat the market and deliver excess returns back to the beta component. "The strategy is conditioned on your ability to find a good manager," says Mark Carhart, co-chief investment officer of the Quantitative Strategies Group at Goldman Sachs Asset Management in New York.

Portable alpha strategies tend not to be correlated with one another. "If one portable alpha strategy does very well in a given month, another portable alpha strategy may not do as well," says Robin Diamonte, a managing director of Verizon Investment Management, which manages Verizon Communication's $40 billion defined benefit plan as well as $25 billion in defined contribution and other plan assets. "That's good because over time it means they both add value. Your consistency of alpha stays strong because it is diversified."

About 5 percent of International Paper's $320 million allocation to portable alpha is leveraged with S&P 500 swaps. The remaining 95 percent is spread among three funds of hedge funds.

During its first 12 months, the allocation beat the S&P 500 index by 3.2 percentage points, a reflection of active manager skill. For International Paper, portable alpha was a means to invest in hedge funds. "What we wanted was a well-diversified portfolio that would encompass the most commonly used hedge fund strategies," says IP's Hunkeler.

Cooper Industries has used portable alpha strategies for the equity portion of its portfolio since 1998. According to Dwight Kadar, director of investment management for the company's pension fund, Cooper Industries now uses portable alpha for its entire $360 million equity portfolio, which makes up about 60 percent of total plan assets.

Using two fixed-income managers and one index arbitrage manager, the fund generated 100 basis points of alpha over the S&P 500 in 2003. It uses 5 percent -- or $18 million -- of its equity portfolio to purchase $360 million in S&P 500 futures contracts. The fund invests the remaining 95 percent of its equity portfolio among three managers. Two are fixed-income firms, Pimco and Western Asset, that use futures or other derivatives to mimic the S&P index while actively managing the cash in a portfolio of short-duration fixed-income securities. The third manager, Westridge Capital Management, handles the index arbitrage portion of the portfolio.

When alpha and beta are separated, as they are in portable alpha strategies, investors know precisely how much they are paying for their active asset management. That's a powerful piece of information, investors and money managers agree. "It's transparent pricing," says David Kabiller, co-founding principal of $12 billion-in-assets AQR Capital Management, which employs quantitative and hedge fund strategies. "Clients can figure out what they're paying for, how to budget their risk and how to allocate their capital."