AIMA

The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

Differentiating fixed-income performance with portable alpha

Joseph F. Benning

The Chicago Board of Trade

Q3 2006

 

Recent studies suggest that substantial amounts of money are likely to continue to pour into alternative investments. However, the source of the capital inflows appears to be shifting rapidly. Previously, wealthy individuals were the main source of new funds. Now, funding is increasingly institutional. Capital inflows from endowments, pension funds and foundations are soon expected to account for up to 50% of the net new money into hedge funds.


The shift in the balance of funding sources is likely to have a profound affect on how the industry operates. Institutional goals and expectations are likely to differ substantially from those of individuals, particularly regarding returns, volatility, style and portfolio management skills. Institutional investors are likely to demand greater precision and more clarity in performance attribution. Competition is likely to intensify as money mangers seek to differentiate themselves in an increasingly crowded field marked by strategy convergence as new entrants seek to replicate the successes enjoyed by established hedge funds.
One way for fund managers to differentiate themselves, and investors to monitor performance, is to separate alpha from beta.
Portable alpha seeks to partition returns into those generated by investment management skills (alpha) and those generated by the market (beta). The alpha portion of returns can then be ported over and harnessed to a wide range of desired benchmarks using derivatives. In this way investors can enjoy greatly increased flexibility in the choice of money managers and investment styles. Moreover, investment strategy choices do not need to be tied to any particular asset class or market. Plan sponsors can disaggregate the returns of fully funded investments into alpha and beta components to better align investment objectives with a manager’s performance. But implementation is easier said than done.


For instance, compare an actively managed fixed-income portfolio with one that has adopted a portable alpha strategy. Alpha expectations would typically be low for an actively managed fixed-income portfolio. For one, transaction costs are liable to be high; coupon reinvestments are not frictionless, and frequent adjustments typically have to be made to keep up with cash market index changes as new issues come to market and older ones mature. High transaction costs are particularly painful in low rate environments.


On the other hand a portable alpha strategy has the potential to reduce transaction costs, maintain desired market exposure and add non-correlated returns. Implementing the strategy involves three steps: risk budgeting, acquiring beta exposure and choosing alpha managers. Risk budgeting requires taking into account the desired level of aggregate risk from both the market and from active management, after which investment capital is allocated accordingly. Active managers (the alpha generators) are then fully funded, after which the desired market exposure (beta) is acquired using derivatives. The remaining cash is invested in Treasury Bills and used for margin against derivative positions.


Acquiring beta
 

Implementation of the strategy requires levered acquisition of exposure to the target market, normally defined in terms of a benchmark index. In equity markets, this type of exposure is relatively easy to obtain. For instance, an Over-the-Counter (OTC) swap might be executed against the benchmark. Replication of the benchmark through margin purchases of the components is possible. A much simpler solution is with exchange traded futures contracts, which can easily be bought on margin against virtually any of the major stock market indices.


But levered index replication in cash fixed-income markets can be difficult. It entails large transaction costs and is subject to tracking error. A swap can be executed against the benchmark, but customised swaps can be relatively illiquid. High transaction costs associated with tracking the benchmark cash index will be embedded in the swap price and the swap may involve significant counter-party risk. As of this writing, the major commodities exchanges do not trade futures contracts on major cash bond indexes, so that route is not readily available. Active trading of fixed-income based ETF’s is picking up steam, but those instruments tend to be narrow-based, representing sectors of fixed income markets, rather than the market as a whole. In addition, fixed-income sector indices carry implicit idiosyncratic risk related to the behavior of the yield curve.
The problem of sectoral bias in the choice of a returns target became explicitly clear over the last two years with the rise of short rates and fall of long rates as the Fed tightened policy and inflation expectations waned. One possible solution to this problem is to use total return swaps to gain exposure to a newly developed type of fixed-income index that weights components evenly across the maturity spectrum.


Finding alpha
 

While beta is acquired, alpha has to be sought out. The primary rule is to find it wherever it lives. Since alpha is independent of the market (or asset class) in which it resides, a benefit of separation is an increase in the manager selection pool. But that is not an unmixed blessing; picking and monitoring investment managers requires skill. And to properly separate alpha from beta, manager selection criteria will need to examine factors independent of asset class. Those factors will be the ones that hedge funds and other alternative asset managers will need to use in order to differentiate themselves. The relative ease with which beta can be acquired with derivatives, listed or otherwise, will therefore have the effect of focusing attention on a manager’s ability to produce pure alpha—from whatever source.


For the porting strategy to make sense, alpha needs to be independent of beta. To the extent that a fund manager’s alpha generation is correlated with any particular market, it may be necessary to neutralise the implicit beta. Isolating alpha from beta within a strategy or asset class and then neutralising it requires a fair degree of sophistication. Fortunately, recent history shows little correlation between Treasury market returns and some of the more prevalent hedge fund strategies. For instance, an examination of six strategies tracked by Dow Jones Indexes (convertible arb, distressed securities, event driven arb, equity neutral, mergers and equity long/short) produced statistically significant correlations between the daily logged returns of most of the strategy indices, but only one strategy (convertible arb) correlated with Treasury market returns as measured by the Dow Jones CBOT Treasury Index (DJCBTI). These results suggest that alpha generated by traditional hedge fund strategies may be particularly well-suited for porting onto Treasury market returns (see Figure 1).

Figure 1: Hedge fund strategy correlations

Differentiating Fixed-Income Performance

 

Two other issues need to be considered. First, it is preferable that sources of alpha generation be diversified to reduce risk. Second, returns produced by alpha managers need to consistently exceed returns available from cash freed up by acquiring beta with derivatives. Generating alpha requires risk-taking; buying Treasury bills does not. An alpha generator therefore needs to beat the Treasury bill rate by a margin sufficient to justify the implicit risk of an active management strategy. Matching but failing to beat cash implies market returns, but with increased risk. Failure to match cash implies total returns below those that would have otherwise been achieved.


To sum up, portable alpha provides a way for alternative investment managers both to offer enhanced returns and to differentiate service quality by focusing on the ability to consistently generate excess returns. Porting alpha requires the ability to replicate beta at low cost, a job well-suited to derivatives, whether exchange traded or OTC. While the tools for replicating equity beta exposure have been readily available for some time, the task of efficiently replicating generalized fixed-income exposure has been more problematic. However, new classes of Treasury market benchmarks have simplified gaining Treasury market exposure, clearing the way for implementing portable alpha strategies around core Treasury holdings.


Note: Opinions expressed in this article are solely those of the author and should not be interpreted as representing either the position or opinion of the Chicago Board of Trade

References:
Casey, Quirk & Acito Institutional Demand for Hedge Funds: New Opportunities and New Standards, 2004 http://www.cqallc.com/whitepapers/index.asp
Chow, George & Kritzman, Mark Risk Budgets Revere Street Working Paper Series, Financial Economics 272-5
Kohler, Adele Implementation Guide for Portable Alpha & Efficient Beta Exposure, State Street Global Advisors

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