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

Casey, Quirk & Acito Institutional Demand for Hedge Funds: New Opportunities and New Standards, 2004
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

Back to Listing

Main Menu

  1. Home
  2. About
    1. Our Core Objectives
    2. AIMA's Policy Principles
    3. Meet the team
    4. AIMA Council
    5. Global Network
    6. Sponsoring Partners
    7. Opportunities at AIMA
    8. AIMA’s 25th anniversary in 2015
  3. Join AIMA
    1. Benefits of Membership
    2. Membership Fees
    3. Application form
  4. Members
    1. AIMA DDQs
    2. AIMA Annual Reports
    3. AIMA Governance
    4. AIMA Logo
      1. Policy note
    5. AIMA Members' List
    6. AIMA Review of the Year
    7. Committees and Working Groups
    8. Weekly News
    9. Update Profile
  5. Investors
    1. AIMA Investor Services
    2. AIMA Members' List
    3. Investor Steering Committee
  6. Regulation
    1. Asset Management Regulation
      1. EU Asset Management Regulation
        1. AIFMD
        2. European Capital Markets Regulation
        3. MiFID / MiFIR
        4. UCITS
        5. European Venture Capital Directive
        6. Shareholder Rights Directive
        7. European Long Term Investment Fund Regulation
        8. Loan Origination Funds
        9. Capital Raising
        10. AIFMD-Related Events
      2. US Hedge Fund Adviser Regulations
        1. Registration and Reporting
        2. Incentive-Based Compensation
        3. JOBS Act
      3. Asia Pacific Asset Management regulation
      4. Other Jurisdictions’ Asset Management Regulation
      5. Private Placement Regime
        1. Canada
        2. Dubai
        3. Finland
        4. Germany
        5. Hong Kong
        6. Japan
        7. Saudi Arabia
        8. Sweden
        9. United Arab Emirates
      6. Systemically Important Financial Institutions ('SIFIs')
      7. Remuneration
        1. UK
        2. United States
        3. CRD IV and CRR
        4. AIFMD
        5. MiFID
      8. Shadow Banking
      9. Volcker Rule
      10. Other
      11. Systemic Risk Reporting
      12. Dealing Commission
      13. Corporate Governance
      14. Securitisation
    2. Markets Regulation
      1. Bank/Capital Regulation
        1. Capital Requirements Directive
        2. EU Bank Structural Reforms
      2. Capital Markets Union
      3. Derivatives/Clearing
        1. EMIR
        2. MiFID II / MiFIR - Derivatives
        3. MAD / MAR
        4. Dodd-Frank Act Title VII
        5. Hong Kong
        6. IOSCO
        7. Singapore
      4. High Frequency Trading
        1. EU automated trading
          1. ESMA Guidelines
          2. Germany
          3. MiFID II / MiFIR - HFT
        2. US automated trading
          1. SEC Regulation SCI
          2. CFTC Automated Trading
        3. IOSCO
        4. Flash Crash
      5. Insurance Regulation
        1. Solvency II
      6. Market Abuse
        1. MAD / MAR
        2. Indices as Benchmarks
      7. Position Limits
        1. MiFID II - Commodities
        2. CFTC Position Limits
      8. Resolution of Financial Institutions
        1. Europe
          1. EU Bank Recovery and Resolution Directive
          2. EU Non-Bank Recovery and Resolution
        2. CPSS-IOSCO
        3. Financial Stability Board
        4. UK
        5. USA
      9. Shadow Banking
        1. International Shadow Banking
        2. EU Shadow Banking - SFT reporting & transparency
      10. Short Selling
        1. EU Short Selling Regulation
        2. Hong Kong Short Selling Regulation
        3. US Short Selling Regulation
      11. Trading
        1. Dodd-Frank Act
        2. MiFID Portal
        3. REMIT
        4. Securities Settlement
    3. Tax Affairs
      1. Automatic Exchange of Information (AEOI)
        1. FATCA
        2. EU - AEFI
        3. OECD - Global Standard on AEFI
      2. Australia - Investment Manager Regime (IMR)
      3. Base Erosion - Profit Shifting (BEPS)
      4. FIN 48 and IAS 12
      5. Financial Transaction Tax (FTT)
      6. UK Investment Management Exemption (IME)
      7. UK Offshore Funds Regime
      8. Other
    4. AIMA's Policy Principles
    5. Search
    6. Resources
      1. Guidance Notes
      2. Jurisdictional Guides
      3. Noticeboard
        1. AEOI: FATCA and other regimes
        2. AIFMD
        3. Bank/Capital Regulation (including NSFR)
        4. BEPS
        5. CFTC Registration and Exemptions
        6. Corporate Governance
        7. Dealing Commission
        8. Derivatives
        9. FTT
        10. High Frequency Trading
        11. MiFID / MiFIR
        12. Other Hot Asset Management Topics
        13. Other Hot Markets Topics
        14. Other Hot Tax Topics
        15. Position Limits
        16. Trading
        17. UCITS
        18. UK Partnership Tax Review
        19. US State and Local Taxes
        20. Volcker Rule
      4. Hedge Fund Manager Training
      5. Quarterly Regulatory Update
      6. Webinar Programme
      7. Regulatory Compliance Association
        1. About the Regulatory Compliance Association
        2. RCA Curricula and initiatives for alternative investment firms
        3. Meet the regulators and Sr. Fellows
  7. Education
    1. Research
      1. AIMA Research
      2. Industry research
      3. Search research documents
    2. "The Case for Hedge Funds"
      1. Global Hedge Fund Industry Paper: The value of our industry
      2. The Value of the Hedge Fund Industry to Investors, Markets and the Broader Economy: Research commissioned by AIMA and KPMG
      3. The Evolution of an Industry: KPMG/AIMA Global Hedge Fund Survey
      4. Contributing to Communities: A global review of charitable and philanthropic activities by the hedge fund industry
      5. Beyond 60-40: The evolving role of hedge funds in institutional investor portfolios
      6. The Cost of Compliance: Global hedge fund survey by AIMA, MFA and KPMG
      7. Capital Markets and Economic Growth: Long-term trends and policy challenges
      8. Apples and Apples: How to better understand hedge fund performance
      9. The Extra Mile: Partnerships between hedge funds and investors
      10. Key articles by AIMA on the case for hedge funds
    3. AIMA Journal
      1. Recent issues
      2. Search AIMA Journal articles
      3. AIMA Journal Archive
    4. AIMA Guides to Sound Practices
    5. AIMA guides for institutional investors
    6. CAIA Association pages
      1. Fundamentals of Alternative Investments
    7. Regulatory Compliance Association pages
      1. About the Regulatory Compliance Association
      2. RCA Curricula and initiatives for alternative investment firms
      3. Meet the regulators and Sr. Fellows
    8. Certified Investment Fund Director programme
    9. Services to Start-up Managers
    10. Glossary
  8. Events
    1. AIMA Events
      1. AIMA Annual Conference
        1. AIMA 25th Anniversary AGM & Annual Conference
      2. AIMA's Global Policy and Regulatory Forum
        1. 2015 Forum - Review
        2. 2015 Forum - Photos
        3. 2015 Forum - Agenda
        4. 2015 Forum - Sponsors and Supporting Organisations
    2. AIMA webinars
    3. Industry events
  9. Media
    1. Press Releases & Statements
    2. AIMA's blog
    3. Media Coverage
      1. Articles by AIMA
        1. Archive
      2. AIMA in the news
      3. Video interviews
      4. Industry news
    4. Media Contact
    5. Press Materials

Sub Menu

  1. Education
    1. AIMA Journal
    2. Bibliography
    3. CAIA Designation
    4. Research
    5. Roadmap to Hedge Funds
    6. AIMA's Investor Steering Committee Paper
    7. Glossary
  2. Regulatory, Tax, Policy & Government Affairs
    1. AIMA Position Papers
    2. AIMA Responses
      1. Australian Tax Office
      2. Authority for the Financial Markets
      3. Committee of European Banking Supervisors
      4. Committee of European Securities Regulators
      5. Commodity Futures Trading Commission
      6. Dubai Financial Services Authority
      7. European Commission
      8. European Securities and Markets Authority
      9. Swiss Financial Market Supervisory Authority
      10. Financial Services Authority (UK)
      11. Financial Services and the Treasury Bureau
      12. Guernsey Financial Services Commission
      13. HM Revenue & Customs
      14. HM Treasury
      15. Independent Commission on Banking
      16. IOSCO
      17. Monetary Authority of Singapore
      18. Securities and Exchange Board of India
      19. Securities and Exchange Commission (USA)
      20. Securities and Futures Commission
      21. Singapore Exchange
      22. The Takeover Panel
      23. US House of Representatives / Senate
      24. Federal Deposit Insurance Corporation
      25. Financial Stability Oversight Council
      26. Financial Stability Board
      27. US Treasury
      28. Internal Revenue Service
      29. US Federal Reserve
      30. Financial Industry Regulatory Authority (FINRA)
      31. Council of European Union
      32. Hong Kong Exchanges and Clearing
      33. House of Lords
    3. AIMA Summaries
      1. CESR
      2. European Commission
      3. Financial Services Authority (UK)
      4. HM Revenue & Customs
      5. HM Treasury
      6. IOSCO
      7. Securities and Exchanges Commission
      8. FSOC
      9. CFTC
    4. Guidance Notes
    5. Jurisdictional Resource
    6. AIMA Noticeboard
      1. EU Directive on Alternative Investment Fund Managers
      2. FSA Remuneration Code
      3. Short Selling
      4. US Dodd-Frank Wall Street Reform and Consumer Protection Act
      5. UK Stewardship Code
      6. Securities Law Directive
      7. EU Directive on Alternative Investment Fund Managers - Level II
      8. EU Directive on Markets in Financial Instruments (MiFID)
      9. International Financial Centres
      10. Bribery Act
      11. Market Abuse Directive
      12. MF Global
      13. FATCA
      14. FTT
      15. Other Tax Issues
    7. AIMA Regulatory Update
  3. Sound Practices
    1. Due Diligence Questionnaires
    2. Guides to Sound Practices
  4. Start-Up Service Providers
  5. Useful Websites