Google searches for “portable alpha” peaked in August 2006, then dropped off precipitously over the next two years. By mid–financial crisis web users’ interest in the derivatives overlay strategy averaged one sixth of the 2006 level. Now “portable alpha” barely registers on Google Trends owing to scanty search activity. For every time someone googled the term in February, there were seven searches for “risk parity.”
Which is probably healthy.
Perhaps the only instance of risk parity causing real, fund-level problems happened more than two years ago in San Diego County. It required assists from alarmist local-newspaper editorials (“Be nervous, county taxpayers and pensioners — very nervous”), warring board members (“I deeply fear for my safety”), and the troubled outsourcing of a then–$10 billion public fund.
Portable-alpha strategies, in contrast, blew up so frequently during the financial crisis that for some the term came to be synonymous with “inscrutable risk grenade,” or perhaps “synthetic Russian roulette.”
Irons can also be death traps — for those who press their clothes while wearing them.
First, a definition: “The alpha piece is the extra return that the ‘brilliant’ insights of an active manager can produce,” explains Daniel Scholz, investment strategies director for NISA Investment Advisors. NISA, based in St. Louis, Missouri, runs portable-alpha programs for five clients. “The portable part is, rather than take that alpha from whatever the manager does — oil or currency, for instance — [you can] port it onto any kind of market exposure that the end investor wants. The classical iteration is that if you had an active stock picker but didn’t want equity exposure, you could synthetically unwind the equity exposure and use another derivative to add, say, fixed-income exposure.”
Step 1: Corral the alpha, any alpha. Step 2: Pick the best beta (for your portfolio). Step 3: Hire a manager (probably) to fund with a Step 1 exposure to Step 2 via derivatives.
What went so very wrong with some of these programs in 2008?
“Normalize everything to $100,” Scholz says in describing how the strategies sank. “If you wanted to enhance equity exposure, you’d take a certain fraction and give it to hedge funds and take another fraction to facilitate margin payments on derivatives. It is our understanding that where portable-alpha programs ran into trouble in the [global financial crisis], a lot of the dollars, say $80, went to hedge funds and $20 to cash, and when derivatives were marked-to-market, the $20 ran out. Some hedge funds gated redemptions, so investors had to go elsewhere for that liquidity. The investors that really got in trouble had to use assets that weren’t liquid, either. Those were hard decisions to make back at that time.”
Portable alpha hasn’t made a sustained comeback the way some crisis-era products, such as mortgage-backed securities, have. Rather, it’s become the domain of a small number of sophisticated asset allocators and specialist managers. The Alberta Investment Management Co., for example, reportedly leverages its hedge fund portfolio via an internally managed portable-alpha strategy.
“We can have, say, Canadian beta and then receive alpha from a global alpha pool that has a diversified mix of exposures,” AIMCo chief investment officer Dale McMaster told the Top 1000 Funds news site in 2016. “It’s all about finding the most cost-effective way to deliver alpha and beta.”
But to find the hotbed of postcrisis portable alpha, one should look to Missouri. The $8 billion Missouri State Employees’ Retirement System (MOSERS) launched its program more than 15 years ago. “They ran it with success for well over a decade, and that introduced the strategy to a number of pension plans in the state,” says Thomas Richards, CIO of the University of Missouri’s $7.5 billion pension, endowment, and working capital funds. Richards and his team introduced a small portable-alpha program a number of years ago, capped at 7 percent of capital. MOSERS’ experience “helped a huge amount with our board,” Richards explains, “because we could sit down and talk to people in our state that had actually done it, and very successfully. It was not a new concept.”
Last summer, Richards returned to the UM board and put up some of the original slides he’d used to initiate the program and predict how it would perform. “That’s exactly what it did. From a risk perspective, yes, we expanded it to 20 percent of capital, but at the same time, we are dramatically reducing risk in certain other areas of the portfolio” — namely, public equities. “It was very helpful to us to bring in NISA, a firm based just down the road, which has particular expertise in derivatives implementation,” Richards says. For UM, “portable alpha is done prudently with a good partner — we wouldn’t be doing it ourselves.”
The cost of portable alpha makes it appealing. “Manager cost is probably the most significant element,” according to NISA’s Scholz. “The hedge funds hired will account for the lion’s share of total fees, and then the overlay manager’s (NISA’s fees, in this case) are a relatively small portion. And finally, to the extent that something’s done with the cash — like a money market fund — there will be fees.”
But, he notes, “the setup costs can be substantial, including the legal documentation to do the program. The second part is structure costs — the financing costs embedded in the overlay. Efficient execution is one aspect NISA tries to market.”
In addition to expanding the size of the program, UM will also begin porting its hedge fund alpha onto Treasury, TIPS, and commodities exposures. (It had previously stuck to an equity-only overlay.) “One of our larger challenges has been transitioning to the new allocation: out of equities and into TIPS and Treasuries,” Richards says. “We’ve been methodically reducing equities each month and layering in on both ends, so we’re not taking any big risks in terms of market timing. We’ve been able to gradually build out that position as rates are rising.”
Much of the change to UM’s portfolio comes from the philosophy that neither Richards nor his team can foresee asset prices and market movements. “No one can, and when people think they can, you should doubt them,” the CIO says. “It’s an element of humility to acknowledge that we’re not smart enough to predict markets, so as much balance as you can tolerate is better.”
Ken Raguse, a portfolio manager for SSI Investment Management, which has run derivatives strategies since 1995, puts it succinctly: “Why is portable alpha coming back? It’s working.”