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

to write the book “Portable Alpha Theory and Practice: What
Investors Really Need to Know,” turning in our first draft to
the publisher well before August 2007. Our colleague Chris
Dialynas put it best in the epilogue:
“Ironically, what began in the early 1980’s as a simple
finance arbitrage Pimco portable alpha strategy has
evolved in some cases to highly leveraged, unregulated
portable alpha hedge fund strategies. Both are referred
to as the alpha source in a portable alpha context,
but they are vastly different in terms of the potential
downside risk.”
Alpha And Beta: It’s the Combination
That Matters, As Does The Execution
This is not to say that all portable alpha strategies that
involve the use of hedge funds as the alpha strategy are bad
or highly risky. There are surely any number of successful,
prudent approaches that involve hedge funds. Regardless of
the approach, though, as a starting point, proper quantification
of investment and operational risk in portable alpha programs
is a necessary ingredient to well-informed investment,
benchmarking, risk budgeting and asset allocation efforts.
Risk management and measurement is a crucial component
of a successful portable alpha strategy.
While portable alpha may seem to be an elegant and
low-risk way to earn excess returns in addition to the return
from the reference market index, there really is no such thing
as a free lunch in the financial markets. The fundamental
laws of investing apply to portable alpha just as they do to
any other type of investment. It is almost always necessary
to take some type of risk in order to generate return over
money market rates. While portable alpha strategies may
seem simple in theory, they cannot outperform the reference
index 100 percent of the time. The primary risks of portable
alpha strategies in this regard can include: (1) the potential
for under-performance in the collateral (alpha) portfolio, (2)
a spike in the financing costs for futures/swaps, (3) margin
calls on the derivatives in a falling market, which force the
liquidation of the most liquid (and highest-quality) parts of
the portfolio, or (4) operational errors.
Investors should carefully evaluate both the risk of
the derivatives-based index exposure and the alpha strategy
when attempting to understand the overall risk of the
strategy. Focusing first on the alpha side of the equation,
investors should understand the liquidity of the portfolio.
Futures margin is typically settled on a next-day basis, and
swap collateral requirements may be settled as frequently
as daily in stressed market environments. Consequently,
understanding portfolio liquidity is critically important.
Similarly, understanding the alpha portfolio’s expected
behavior during periods of market stress may provide
insight into how the portfolio as a whole behaves in down
markets. Well-informed analysis will focus on the sources of
return in the alpha portfolio and the risk factor exposures
that drive those returns. Further analysis should focus on
the likely correlation of those risk factors across different
market environments and to what extent the risks are identifiable,
measurable and can be diversified.
Figure 3
Bonds Plus? Or Something Else Entirely…
Passive
Bonds
(Barclays Agg)
Source: Bloomberg and Hedge Fund Research Inc.;
hypothetical example constructed by Pimco
Portable Alpha
Using Hedge Funds
(Passive Beta =
Barclays Agg)
2008
Return 5.24% -17.19%
Volatility 6.09% 13.04%
10-Year Period
Return 5.63% 9.26%
Volatility 3.84% 8.24%
Beta vs S&P 500 -0.02 0.33
Correlation vs S&P 500 -8.86% 61.25%
Correlation vs BCAG 100.00% 45.84%
For instance, combining a derivatives-based fixed-income
index exposure with a hedge fund alpha strategy may result
in a strategy with a very different risk profile than the passive
fixed-income index. This can be problematic because the
passive fixed-income index presumably serves as the benchmark
for the overall strategy and also serves as the proxy for
the strategy in the investor’s asset allocation. An illustrative
example is shown in Figure 3.
The analysis in Figure 3 compares a hypothetical investment
in a portable alpha strategy where the collateral portfolio
is invested in the HFRI Fund-Weighted Composite Index
(the HFRI composite index provides an equal-weighted average
return of over 2,000 hedge funds). The derivatives-based
beta or index returns are approximated by the return of the
Barclays Aggregate Bond Index minus 3-month LIBOR.
How satisfied would an investor have been with this
investment in 2008? Based on a cursory review of the data in
Figure 3, it is challenging to have much to say on the positive
front in light of:
• A negative excess return of 22.4 percent and negative
absolute return of 17.2 percent (the bond index
returned a positive 5.2 percent)
• Over two times the volatility of the passive bond index
But had you been invested in the strategy for the last 10
years, how satisfied would you be? Even with 2008’s challenges,
the strategy referenced in this example produced a very
healthy excess return of 3.6 percent (excluding any overlay
costs, other costs and fees and “slippage” related to imperfect
alignment between the value of the underlying hedge fund
investment and the bond overlay). Very nice to have the extra
returns for sure, but is this really a bond investment? Look
closely at the risk statistics. The strategy exhibited more than
double the volatility of bonds and was more correlated (61
percent) with the S&P 500 than with the Barclays Aggregate
(46 percent). So not only might it be debatable as to how
to classify this investment, it may be challenging to properly
benchmark the strategy. Based on the historical performance
characteristics of the strategy, can one really assume that it
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