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

Portable alpha approaches—which essentially involve
seeking beta from one asset class and alpha from
another—have fallen under a cloud, as have many other
investment strategies, in the wake of the recent market turmoil.
However, they can yield potentially powerful results
for investors both in terms of risk-adjusted excess return and
diversification benefits, which explains, at least in part, the
heightened interest in portable alpha following the equity
market sell-off in 2000–2002. Traditional stock and bond
investment return expectations were relatively low, and
investors were concerned about meeting return targets that
were in many cases in the 7–10 percent range. As a result,
investors as a group were more open to new investment categories
and approaches, including those that employ the use
of derivatives and leverage, like portable alpha.
At the time, portable alpha and related concepts were
touted as a new paradigm in investment management, and
even the holy grail of investing. The variety of different
approaches to porting alpha and the number of providers of
related products ballooned, as did the conferences dedicated
to the topic. Generally speaking, investors seemed happy
with the results. Of course, most of the newer approaches to
portable alpha were implemented in the low- and decliningvolatility
environment that ended in 2007, with risk premiums
initially rising to levels closer to historical averages
before spiking to new highs this past fall.
Unfortunately for some investors, successful portable
alpha implementation has proven to be much more complicated
in practice than it may sound in theory. Portable-alpharelated
losses experienced by some have been highlighted in
the public domain, likely causing some investors to question
the merit of the entire concept.
What does the future hold for portable alpha? The fundamental
concepts that provide the basis for the viability
and benefits of portable alpha for long-term investors are
very much alive and well. There have been important lessons
learned, though. As a result, we are likely to see a bifurcation
of the marketplace where portable alpha approaches that
share certain important characteristics are likely to survive
and even thrive, while others may disappear. In particular,
we believe approaches that capitalize on the attractive risk
premiums available in the high-quality, relatively liquid fixedincome
arena merit serious consideration by investors.
Portable Alpha, Defined
Not surprisingly given the wide variety of approaches
employed, the definitions of the term “portable alpha” vary
depending on who you ask. So far as we are aware, though, all
strategies that fall under the portable alpha umbrella involve
the use of derivatives (or a similar borrowing arrangement)
to obtain the desired asset class or market index exposure,
typically referred to as “beta,” thereby allowing risk-adjusted
excess returns or “alpha” to be sourced from an entirely distinct
asset class or active management strategy. Central to
the idea and also the potential value of portable alpha are the
concepts of borrowing to achieve higher returns, and diversification
as a means to increase the return per unit of risk. Sound
familiar? These are also two of the key concepts that underlie
Figure 1
Alpha
Strategy
Return
over LIBOR
Source: Pimco
Figure 2
$1
$1
$1
Source: Pimco
What Is Portable Alpha?
Alpha
Market
Exposure
“Beta”
Derivatives-Based Market
Exposure “Beta”
Capital Investment
C
“Alpha Strategy”
Alpha: Risk-adjusted
excess return
Desired “beta” market returns
generally obtained using futures
or swaps at LIBOR-based cost
Derivatives Allow Capture Of Additional
Return Source And Risk Diversification
strategy
modern portfolio theory as introduced in the middle of the
20th century and detailed in every investment textbook.
The potential diversification benefit is derived from the
fact that an investor’s capital may be invested in assets that
are independent from—and complementary to—the derivatives-based
beta exposure. Let’s say that an investor has $1.
They can buy $1 of the desired index exposure for just a few
pennies using derivatives, and have the rest of the $1 to place
in an entirely separate and distinct investment. Simplistically
speaking, the combined return will be equal to the total
return of the index (beta) minus the associated financing rate
(as explained below) plus the total return of the collateral or
alpha strategy. The returns from the two components are
additive, while the risk is not entirely additive—as it would
be if the two were perfectly correlated.
It is difficult to predict future correlations: Assets that historically
have not been correlated or have had relatively low
correlations during periods of low volatility may turn out to
have very high correlations during periods of market stress.
Nonetheless, so long as the risk factor exposure in the alpha
strategy is transparent, investors should be able to determine
whether or not a material, positive diversification benefit
should exist over the long term. One example of this may be
the combination of equity derivatives and a carefully risk-controlled,
high-quality, fixed-income alpha strategy portfolio. Of
note is the fact that the Barclays Capital U.S. Aggregate Bond
$2
www.journalofindexes.com July/August 2009
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