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

Figure 4
will behave in a similar manner as the passive bond index?
Return and especially risk assumptions should be ratcheted up
for any plan-level risk budgeting and asset allocation efforts.
These same challenges are likely to present themselves
when the derivatives-based beta exposure is an equity
index. In addition, the actual and potential volatility and
downside risk of the equity market is very relevant when
considering the appropriate level of liquidity in the collateral
alpha strategy—as many who executed portable alpha
strategies during the relatively benign low-volatility and
positive equity market return period from 2003 to mid-
2007 can certainly now attest.
In Figure 4, note the differences between the passive S&P
500 Index performance in 2008, and over the last 10 years,
relative to a hypothetical portable alpha strategy. As before,
the hypothetical returns assume that the collateral portfolio
is invested in the HFRI Fund-Weighted Composite Index
and the passive index derivative return is approximated by
the return of the S&P 500 minus 3-month LIBOR. Over the
10-year period, the strategy generated very attractive excess
Figure 5
Portable Alpha Example: Equity Overlay
Passive
Equities
(S&P 500)
Source: Bloomberg and Hedge Fund Research Inc.;
hypothetical example constructed by Pimco
Components Required For Successful
Portable Alpha Approaches
Portable Alpha
Using Hedge Funds
(Passive Beta =
S&P 500)
2008
Return -36.99% -51.76%
Volatility 21.02% 29.33%
10-Year Period
Return -1.38% 1.15%
Volatility 15.10% 21.07%
Beta vs S&P 500 1.00 1.36
Correlation vs S&P 500 100.00% 97.19%
Correlation vs BCAG -8.86% -6.64%
“Beta” (Derivatives Exposure)
– Liquidity
– Cost efficiency
“Alpha” Sources (Collateral/Cash Investments)
– Liquidity for margin calls
– Low correlation with beta exposure
– Transparent risk exposures
– Long-term capital preservation characteristics
Implementation
– Derivatives, liquidity and asset management skill and infrastructure
– Consolidated risk management, monitoring and reporting
return. However, most striking from a risk standpoint is that
this combination results in an equity beta coefficient that is
nearly 40 percent higher than the index.
Is this still an equity strategy with a risk profile that is
similar to the S&P 500? The answer to that question for
most is probably a resounding “no.” As an interesting point
of comparison, the 10-year historical beta of this strategy
is higher than that of any traditional active equity manager
universe over this time period. 1
We offer these examples not to disparage the concept
of using hedge fund strategies as the collateral alpha strategy
investment, but rather to illustrate how different portable
alpha approaches can have risk-and-return profiles that differ,
perhaps meaningfully, from the referenced passive market
index. Successful portable alpha implementation over the
long term is contingent on appropriate risk management and
measurement—which, in turn, requires an appropriate level of
transparency. Again, we believe an understanding of the potentially
higher downside risk of such a strategy is important at the
individual investment, asset class and overall plan levels.
Derivatives-Based Beta Management
Should Not Be Free!
Although often overlooked in marketing presentations that
are focused on the alpha side of the equation, derivativesbased
beta management is not nearly as easy or straightforward
as many believe. Derivative instruments are the principal
building block for portable alpha strategies because they allow
investors to finance the desired market exposure at what is
typically a short-term money market rate. However, complexities
exist in liquid markets, such as S&P 500 futures, and even
more so for market exposures that are more complicated to
replicate, like multisector fixed-income indexes. The investment
and operational complexities of establishing and maintaining
such exposures may involve significant costs and result
in additional tracking error and/or counterparty risk.
While a discussion of all of the evolving operational
nuances and requirements associated with the use of derivatives
is beyond the scope of this article, in short, the use of
futures requires Commodity Futures Trading Commission
(CFTC) and other regulatory considerations, daily margin
flow management and usually a quarterly roll of exposure.
The use of swaps introduces legal and contractual considerations.
Other issues to take into account with swaps include
counterparty risk and associated cash flow parameters and
the required typical annual roll of exposure.
The last several months have presented significant tests
for many of the “behind the scenes” efforts related to derivatives
management. Liquidity management was subjected to
an extraordinary stress test at the hands of the severe and
sustained market declines. At the same time, counterparty
risk evaluation became increasingly important in an environment
of uncertainty for many Wall Street broker-dealers.
Disentangling the payables and receivables associated with
derivatives contracts at Lehman Brothers has been an
unpleasant task for many asset managers and their clients.
In circumstances where there were sharp moves in the
net assets of the underlying alpha portfolio, this neces-
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July/August 2009