How to Kill a Black Swan Remy Briand and David Owyong ...

Index had a positive return of 5.2 percent in 2008. Historically,
this index has had a negative correlation with equities during
periods of equity market stress, which logically makes sense
due to the flight-to-quality impact.
The borrowing component of portable alpha approaches
is typically accomplished using index futures or swaps that are
designed to provide the total return of the associated market
index, less a financing rate, as noted above. The financing rate
associated with index ownership using derivatives is consistent
with other “buy now, pay later” forms of asset ownership—financing
an appliance, a car or a house, for example.
The important question from the standpoint of prospective
investors in a portable alpha strategy is: Are there readily available,
liquid, cost-effective derivatives available to replicate my
desired index or beta exposure? In the case of certain indexes
or market exposures, the financing cost may be compelling for
long-term investors, while in others, the cost may be significantly
higher if the exposure is even available synthetically.
The Evolution Of Portable Alpha
The vast majority of portable alpha approaches seek
to outperform the equity market, and thus employ equity
index futures or swaps to replicate the returns of the equity
market on an ongoing basis. This is not surprising, as it was
the introduction of S&P 500 index futures by the Chicago
Mercantile Exchange in 1982 that paved the way for broad
market “portable alpha” index enhancement. Specifically, the
advent of the S&P 500 futures contract presented investors
with the opportunity to maintain exposure to the equity market
over the longer term at a short-term money market rate
cost. For equity futures contracts, this cost is embedded in
the price of the futures contracts and is usually very close to
3-month LIBOR, at least for highly liquid futures contracts. In
the event that it drifts higher for some reason, arbitrageurs
will typically step in, thereby pushing the financing rate back
toward LIBOR. In the case of total return index swaps, the
financing cost is specified as part of the contract, and also
most commonly linked to short-term LIBOR rates.
The key to achieving higher returns than the reference
beta or index lies in the performance of the alpha strategy
relative to the money market cost of financing. It follows that
portable alpha strategies may benefit from a “time horizon
arbitrage” of sorts that is unique relative to most traditional
actively managed strategies, due to the mismatch between
the short-term money market cost of the beta exposure and
the longer-term horizon of the investor. Rather than investing
the capital retained solely in money market investments,
investors can capitalize on their longer time horizon by
investing in assets that bear some amount of additional risk
in exchange for a higher expected return. This was the idea
when Pimco launched its StocksPlus strategy shortly after
the introduction of S&P 500 futures contracts more than
two decades ago: Capitalize on long-term equity investor
horizons by owning equity futures contracts collateralized
by a portfolio of liquid, high-quality, short-term fixed-income
assets that provide a modestly higher incremental yield and
expected return above money market rates.
Over the years, investors have gravitated to portable alpha
for multiple reasons. There is a certain appeal to the concept
in that it reconciles the need for higher returns while still
offering many of the same advantages of passive investing. It
is commonly agreed that passive investing offers many significant
advantages for investors across assets classes, including
low costs, liquidity, capacity, diversification and ease of use.
Portable alpha can offer many (in some cases, all) of these
same benefits. It also is particularly compelling in segments
of the market where it is difficult to identify traditional managers
that produce consistently positive excess returns, such
as the U.S. large-cap equity space. Portable alpha strategies
avoid the risk of individual security selection by “owning
the market” through derivatives, but expand the universe of
strategies that can be employed to generate alpha relative
to a given benchmark. In addition, there may be important
improvements in the overall risk profile if there is a low and
relatively stable correlation between the alpha strategy and
the desired market (“beta”) exposure, as noted above, and
also to the extent that the overall strategy provides excess
returns that are uncorrelated with other actively managed
strategies owned within an asset class.
Given all the potential benefits to investors and the
increased interest on the part of investors, it is not surprising
that a large number of variations of the portable alpha concept
have been introduced by investment managers or undertaken
by investors directly, as discussed toward the beginning of
this article. A related reason for all of the interest and flows
into portable alpha strategies is the substantial growth in the
index derivative markets. Relative to even as recently as five
years ago, the number of available futures contracts is much
broader, now including international and emerging markets
equity contracts as examples. At the same time, the overthe-counter
(swap) markets became substantially more liquid
and active. Movement toward standardized over-the-counter
contractual arrangements has also improved the willingness
of investors to establish such exposures.
It’s important to remember, however, that no strategy
is without risks and pitfalls. Over the past few years, we’ve
seen that portable alpha is not immune to the return-hungry,
risk-agnostic attitude that permeated some parts of the marketplace.
The downside of excessive leverage and poor risk
evaluation and measurement ultimately contributed to the
broad-based market dislocations and de-leveraging we’ve seen
recently. Various portable alpha strategies were marketed
without any mention of the downside risk of the alpha component—the
beta component was assumed to have risk, while
alpha strategies that promised returns of 4 percent over LIBOR
or more (after accounting for very high fees) in some cases
were essentially put forth as being risk-less to the end investor,
such that investors may have been led to believe that their
downside was limited to that of the beta component alone.
In addition, often there was very little mention or consideration
of the liquidity that is absolutely critical to the ability to
maintain the derivatives market exposure during volatile and
downward-trending market environments, among other key
aspects of portable alpha that may have been glossed over.
From our perspective, this was quite concerning—and rightly
so, as it turns out—which is why we actually felt compelled
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July/August 2009