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When equity markets stumble and bond yields drop, falling funding ratios spur many pension plans to re-examine their portfolio strategies in search of higher returns. Canadian fixed-income allocations, which haven’t traditionally been expected to deliver alpha, get increased attention. Enterprising investment managers from asset classes other than bonds begin to pitch portable alpha solutions, proposing to acquire bond market exposure or bond “beta” passively, while adding “alpha” from a different asset class, typically stocks.
Is Canadian fixed income a good asset class for the typical portable alpha approach? In our view – no. While PIMCO manages over $55 billion in portable alpha mandates, we don’t believe it makes sense for all asset classes. In the case of Canadian bonds, the typical portable alpha approach is too costly, probably reduces plan diversification and most importantly, is unnecessary. We elaborate on these points below.
For those who want more information on portable alpha, we have updated and reprinted parts of the short primer we originally published in the fourth quarter 2005 issue of the Canadian Quarterly Review. In addition, PIMCO’s Sabrina Callin recently authored Portable Alpha Theory and Practice which will be published by Wiley next month.
Disadvantages of Portable Alpha for Canadian Fixed Income
1. Too Costly
Most portable alpha strategies obtain synthetic exposure to a desired beta using derivatives, and invest some or all of their cash in an alpha strategy. There is always a borrowing or financing cost associated with establishing synthetic beta. In the case of Canadian bond index exposure, that cost is typically a money market rate (CDOR) plus 25 basis points, but today, thanks to dislocation in credit markets, is about CDOR plus 50 basis points! That cost is a dead weight, meaning that a synthetic portable alpha strategy starts out with a disadvantage versus a traditional cash or physical bond portfolio – the alpha strategy must cover that cost of financing before the investor realizes any alpha. Moreover, the alpha engines used by many portable alpha strategies are hedge funds, which often cost more in management fees per dollar of performance than traditional unlevered strategies.
2. May Reduce Diversification
The alpha engines for many portable alpha approaches are equity oriented absolute return strategies, which often have a materially positive correlation with equities. Since equity market risk already accounts for over 90% of expected risk or volatility in most pension plans (assumes equity allocations of 60% or greater), an equity related portable alpha approach for the bond allocation may reduce plan diversification even further and overwhelm the capital preservation and other qualities that motivated the bond allocation in the first place.
3. Unnecessary – There are Better Alternatives
Contrary to the popular belief in Canada, the fixed-income market can be a good place to source alpha. Successful managers have been able to generate alpha from fixed-income markets on a consistent basis.
Arguably, a Canadian core plus bond style is a portable alpha approach, because it harvests opportunities from global bond and credit markets, as well as from the Canadian bond market. However, in “porting” alpha from other fixed-income markets, core plus avoids the extra costs, incremental risks and operational complexities of the typical portable alpha approach.
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Portable Alpha Theory and Practice
by Sabrina Callin
A practical guide to understanding and implementing portable alpha.
“Sabrina Callin and her colleagues have written a concise and engaging book that captures the key values and the pitfalls of what has come to be known as portable alpha. For those who wish to participate in modern finance this book is a most instructive read.”
—Alan Greenspan, former Federal Reserve Chairman and President of Greenspan Associates LLC
While the interest in portable alpha has grown exponentially, few investors have a true appreciation for the risks and operational complexities associated with this investment application. By first mapping out the key components and evolution of portable alpha, this book aims to give investors a solid foundation in this discipline. From there, it ties in investment theory and asset allocation. Implementation is covered in a dedicated chapter, as is risk management and the increasingly interrelated topic of LDI. Overall, this reliable resource will allow investors, consultants, practitioners, and academics to gain a better understanding of the potential benefits, applications, costs, and risks associated with portable alpha. Sabrina C. Callin, CFA, CPA (Newport Beach, CA), is an executive vice president and head of the StocksPLUS® product management team responsible for PIMCO’s global portable-alpha-based equity business. PIMCO currently manages over $55 billion in portable alpha strategies and is generally credited with being an original innovator of the concept. |
Portable Alpha Primer
(Excerpts from Portable Alpha: Theory and Practice Fourth Quarter 2005 Canadian Quarterly Review)
by Margaret Isberg and Sabrina Callin
What is portable alpha? Descriptions vary, but the fundamental components of a portable alpha strategy are “beta” or passive market return and “alpha” or excess return generated by active management. Traditionally, active manager returns have been comprised of both alpha and beta. A portable alpha approach simply separates the desired beta from the active management, allowing investors to transport the alpha from one strategy or manager to the beta of their choosing. While simple in theory, putting portable alpha into practice requires careful attention to operational details. We’ll review these practical considerations, but first let’s look at the theory.
Beta
The term beta is generally associated with equity market returns, but technically, can refer to any asset class – bonds, stocks, commodities, real estate, etc. In the majority of portable alpha strategies, beta is obtained on a forward basis using derivative instruments. Derivatives enable investors to obtain the desired beta without having to pay for it. Futures are typically the lowest cost way to establish beta, but swaps are becoming an important alternative, particularly when there is no liquid futures contract to proxy the desired beta. There are also a variety of other forward exposure instruments that may be used in some portable alpha-based applications. With the introduction of new derivatives, the list of betas one can buy forward is growing ever larger, and includes some that can be very difficult to invest in directly.
There is a cost, often referred to as the financing rate or borrowing cost, associated with gaining forward exposure to beta. This is true of any arrangement where one obtains an asset such as a house or car or washing machine without paying for it up front. The borrowing cost of beta is typically embedded in the forward price and is tied to a money market interest rate, usually LIBOR (London Interbank Offered Rate). The borrowing cost can vary to a considerable degree across different asset classes and market indexes, as shown below.
Alpha
Because beta is typically financed in a portable alpha approach, most of the cash from the beta allocation is available for investment in the alpha portfolio. The alpha strategy is designed to generate excess return over the borrowing cost of the beta. If it is successful, the investor will be left with the return of the beta plus the excess return of the alpha strategy, as depicted below.*
The number of different alpha strategies that can be employed is infinite, and the strategy need not have any relation to the target beta. For example, equity market beta can be combined with bond manager alpha, or vice versa. An investor’s objectives and risk tolerance will determine which alpha strategies are appropriate, but higher expected alpha generally comes with higher expected risk or uncertainty.
If an alpha strategy embeds undesired beta, it will need to be removed with an offsetting hedge. For example, suppose a pension plan wants to port the alpha from an equity manager who consistently adds value relative to the S&P TSX. If the investor does not want or need additional S&P TSX exposure, they can hire the successful active manager and short the S&P TSX, thereby hedging out the unwanted beta and isolating the manager’s alpha. Of course, doing this may require:
- the availability of liquid S&P TSX derivatives with which to execute the hedge, and
- sufficient returns potential from the alpha strategy to cover the cost of the hedge.
Why go to all the trouble of separating alpha from beta? Because it enables investors to port alpha from strategies that are expected to deliver higher and/or more consistent alpha onto betas where the expectation for alpha is slim.
Additional Costs and Considerations
The portable alpha concept is seductive, but implementation is rarely as simple as implied above. There are critical operational, cash management and risk management complexities that do not typically exist with traditional active stock or bond management approaches.
Derivatives-based Beta
Maintaining beta exposure via derivatives requires significant infrastructure for:
- Maintaining compliance with the rules of the MX, CFTC and other exchanges or regulators.
- The management of legal and contractual requirements associated with derivative positions.
- Trading capabilities to roll derivatives at the most advantageous financing cost.
- An operations/risk management platform that identifies when beta exposure needs to be adjusted for changes in value of the alpha portfolio, to avoid unintentional leverage.
- The assessment and monitoring of counter-party risk.
Liquidity and Cashflow Management
Derivatives positions involve periodic cashflows that can be as frequent as daily in the case of futures, so liquidity management is very important:
- Cash must be readily available to provide to counterparties.
- Cash received from counterparties must be invested in a timely and prudent manner.
- Overall portfolio liquidity must be carefully managed on an on-going basis to accommodate potential margin and swap flows.
- If alpha and beta portfolios are managed by two different managers, there must be tight, on-going coordination between the managers to ensure that the cashflow requirements of the beta portfolio are met.
Alpha Strategy
A portable alpha strategy will be successful if, over the investor’s horizon, the alpha or cash investment strategy can outperform its benchmark (the cost of financing the beta). So, in many respects, picking an appropriate alpha strategy is no different from the typical manager selection process. However, there are significant additional considerations:
- The alpha strategy should be reasonably liquid, especially if the desired market (beta) exposure is relatively volatile, given the potential need to meet material margin/swap flows over short time periods.
- Since the alpha strategy serves as collateral for the “beta” derivatives exposure, long-term capital preservation should be a key objective of any alpha strategy. Therefore, any untested or higher risk strategies should be very carefully evaluated, stress tested and approached with caution.
- The lower the correlation between the alpha strategy and the beta, the greater the diversification of the aggregate portfolio.
- If the alpha strategy is positively correlated with bonds, the aggregate portfolio may deliver a hedging benefit to investors, such as pension plans, whose liabilities are sensitive to changes in interest rates.
Summary
The concept behind portable alpha is relatively straight forward: Obtain desired market exposure using derivatives and enhance that return by investing the cash in a strategy that is expected to deliver returns potential greater than the cost of financing the desired market exposure. Pension plans, which have adopted passive management in asset classes they believe are too efficient to produce reliable alpha, no longer have to forgo alpha on those allocations. However, implementation of portable alpha strategies can be complex, so picking managers with the necessary experience and infrastructure is essential.
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Past performance is not a guarantee or a reliable indicator of future results. This report contains the current opinions of the manager and such opinions are subject to change without notice. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
The products and services provided by PIMCO Canada Corp. are only available in provinces or territories of Canada to investors who are accredited investors within the meaning of the relevant provincial or territorial legislation or rules and in certain provinces, only through dealers authorized for that purpose.
Figure 3 is shown as a hypothetical example for illustrative purposes only and is not indicative of the past or future performance of any PIMCO product. As of 12/31/07, the alpha (after fees) closely resembles the performance of the Lehman Aggregate Bond index performance since inception, and the beta closely resembles the performance of the S&P 500 index performance since inception. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product, or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market risks such as lack of liquidity. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results.
Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. U.S. government securities are backed by the full faith of the government; portfolios that invest in them are not guaranteed and will fluctuate in value. TIPS issued by the U.S. Government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation. Investing in non-U.S. securities involves heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally backed by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax: a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
The S&P/TSX Composite Index is a list of the largest companies on the Toronto Stock Exchange as measured by market capitalization. The Toronto Stock Exchange listed companies in this index comprises about 71% of market capitalization for all Canadian-based companies listed on the TSX. The Standard & Poor’s 500 Stock Price Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. The FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. The equities use an investibility weighting in the index calculation. The index was developed with a base level of 1000 as of January 3, 1984. The DAX Index is a total rate of return index of the most highly capitalized stocks traded on the Frankfurt Stock Exchange. The SMI Index is Switzerland’s key equity index. It represents about 85% of the free-float capitalization of the Swiss equity market. The SMI comprises the 20 largest and most liquid equities of the SPI. The CAC 40 is a French stock market index, a benchmark index for the Paris Bourse (stock exchange). The index represents a capitalization-weighted measure of the 40 most significant values among the 100 highest market caps on the Paris Bourse. Its base value of 1,000 was set on December 31, 1987. As of December 1, 2003, the index has become a free float weighted index. The MSCI EAFE (Morgan Stanley Capital International Europe, Australasia, Far East Index) is an unmanaged index of over 900 companies, and is a generally accepted benchmark for major overseas markets. Index weightings represent the relative capitalizations of the major overseas markets included in the index on a U.S. dollar adjusted basis. The DEX Universe index covers all marketable Canadian bonds with term to maturity of more than 1 year. History dates from December 1979. The Universe contains over 900 marketable Canadian bonds. The average term is 9 years and the average duration is 5.5 years. The purpose of this index is to reflect performance of the broad “Canadian bond market” in a manner similar to the way the TSE 300 represents the Canadian equity market. Prior to 10/22/07, the index was known as Scotia Capital Iniverse Index. The Lehman Brothers Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The Standard & Poor’s 500 Stock Price Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.
No part of this report may be reproduced in any form, or referred to in any other publication, without express written permission. ©2008, PIMCO.
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