23 April 2008
The term “portable alpha” is still a relatively new addition to the popular lexicon. As we’ve written on these pages, the term itself seems to morph on a regular basis to encapsulate the literal “porting” of alpha between asset classes to the combination of hedge funds and swaps. Issues like active management fees, regulation, risk measurement, and market efficiency seem to weave their way in and out of the various definitions of portable alpha.
Now someone has finally brought many of these concepts together in one place. “Portable Alpha: Theory and Practice” (US link) edited by PIMCO’s Sabrina Callin has just hit bookstores. If you read Peter Bernstein’s “Capital Ideas Evolving” (see related posting), you may recall that PIMCO is considered to be one of the early pioneers in portable alpha strategies.
Naturally, we’re working our way through it right now and are so far impressed with the holistic nature of the content (including contributions by Rob Arnott, Bill Gross and several PIMCO managers).
Yesterday, AAA media partner HedgeWorld ran an interview with Callin for its premium subscribers. With permission from our friends at HedgeWorld, we have re-printed the interview in its entirety below.
But before you read the interview, here’s a quick footnote. It appears that Portable Alpha has a lot of fans in the UK and Singapore. A Google search of this book returns the publisher’s country-specific websites in the following order: UK, Singapore, US, Germany, Canada. A flagrantly un-scientific observation for sure. But curious nonetheless…
Portable Alpha in Difficult Markets
By Chidem Kurdas, HedgeWorld New York Bureau Chief, Tuesday, April 22, 2008
But hedge funds that correlate with the market, as many strategies did in March, are particularly dangerous in a portable alpha setting where they can cause double market exposure. At the same time, the credit crunch threatens the solvency of counterparties to derivatives deals.
HedgeWorld asked Sabrina Callin, executive vice president at Pacific Investment Management Co. and head of a team responsible for the firm’s global alpha equity business, how the portable alpha approach will fare in the current environment. She is the author of Portable Alpha Theory and Practice (2008; John Wiley & Sons Inc., Hoboken, N.J.).
HedgeWorld: The idea of separating alpha from beta is not new, is it?
Sabrina Callin: It goes back to the early 1980s, when equity index derivatives were introduced. PIMCO decided to use these in an enhanced a cash product, StocksPLUS. The derivatives add an equity market return to a diversified portfolio designed to outperform money market interest rates. More recently, the same concept was applied by PIMCO and others to replicate various market exposures using derivatives and collateralize that with a variety of different investment engines designed to generate alpha.
HW: There are many potential sources for above-market or uncorrelated returns, hedge funds among them. How do you decide on the alpha source?
SC: We carefully listen to the needs and objectives of our clients. We have introduced combinations that we believe offer attractive long-term returns with limited risk. The client can choose from different market exposures including global equities, small-cap stocks, regional equity markets, commodity exposure, even real estate investment trust exposure. The choice for alpha engine includes enhanced cash, active fixed-income strategies and hedge fund-type strategies.
HW: How does an investor pick from these various components?
SC: Different investors choose the combination that works best for them. It’s very customizable to an investor’s specific considerations. That’s one of the great benefits of this concept. Investors are not limited to managers with a skill in a certain market. They can decide they want that market exposure but then separately select a source for excess return depending on their risk-return preferences.
HW: Have recent market conditions changed the way the portable alpha approach is used?
SC: The broader context of how investors view strategies and markets has changed a lot, but not the way PIMCO does things. Even a year ago, a lot of people were focused on returns and not much on risk. Now the market has come around to the idea that risk matters and therefore diversification of risk matters. Portable alpha can be a fantastic opportunity to diversify risk to provide attractive risk-adjusted returns above a given market index. We’ve always been concerned about keeping risk transparent and at an acceptable level. But investors are now more focused on that.
HW: Has there been a shift in the strategies chosen as alpha source?
SC: The short message is that people want returns uncorrelated to markets. There is greater realization that not everything offered as an alpha strategy with uncorrelated returns can deliver. It may have flaws that will make it correlate with broader markets at times of market stress. I think investors are now placing more value on transparency, which is critically important with portable alpha because you have more exposure.
HW: Regarding the swaps and other derivatives used to get market exposure, is there greater counterparty risk because of the credit crunch?
SC: In the cases where you have liquid futures contracts that you purchase in exchanges, the counterparty risk is minimal. When it comes to swap contracts, we diversify our counterparty risk as part of our established business practice. There are strict controls. For instance, the counterparties never owe any material amount of money to us. The flip side of what’s going on in volatile markets is the power of counterparties to call in the collateral. That caused problems for levered players in the past year. With our portable alpha strategies, the alpha source is highly liquid, so even if there is a decline in the market, we have adequate liquidity. This provides protection if there is a counterparty collateral call.
HW: A portable alpha portfolio is levered up by the use of derivatives. Doesn’t that mean greater risk in the current environment?
SC: Leverage by itself is neither bad nor good. You can have a combination of alpha source and derivative that has less negative return than stand-alone exposure to a market. But the incidence or magnitude of negative return can be higher if the alpha source is high-risk or is significantly correlated with the beta exposure. What matters is that investors take this into account and not assume that this is similar to a stand-alone market exposure.
HW: Is there an estimate of how large the current portable alpha market is?
SC: That’s the million-dollar question! The challenge is how you define portable alpha. For some, it’s just the money in the alpha engine within a portable alpha context. If that were the definition, PIMCO would have more under management because others buy our stand-alone strategies and layer on the beta. From the investor’s standpoint, that’s a portable alpha investment. But we would not include that in our portable alpha number because the investor bought just the alpha engine from us. Our integrated portable alpha strategies are at about $55 billion. There are a number of large pension plans that buy alpha engines and separately implement derivatives positions themselves or through an overlay manager.
HW: Funds of hedge funds manage portable alpha packages. Where do those fit in?
SC: Apart from integrated products like PIMCO’s, there are also semi-bundled products often offered by funds of hedge funds. The derivative and the alpha source are not managed together but the fund of funds offers them as a package. Market neutral funds of funds in particular are increasingly used for portable alpha, with the derivative supplied by the manager or separately obtained by the investor. I haven’t seen any estimates of the assets in semi-bundled products.
HW: What do you see coming in this area?
SC: For an investor who wants to increase return but not take on more downside risk, there are only two options. One is diversification and the other is higher alpha. Those two ways to increase returns are available to a greater degree with portable alpha than with traditional approaches where you have a manager picking stocks or structuring a bond portfolio. That doesn’t mean traditional management is obsolete but it does mean there is a lot of value in the concept of portable alpha because of the much broader opportunity to seek alpha and diversification beyond a selected market.
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