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

sitated more routine adjustment in the notional value of
derivatives to align the value of the overlay with the underlying
assets. The level of volatility underscored the challenges
of attempts to separately manage the alpha and beta
components (as opposed to implementation within a single
integrated portfolio). In such “unbundled” approaches,
the investor typically may bear the responsibility for all of
the risk monitoring, reporting selection and oversight of
separate alpha strategy manager(s) and overlay manager(s).
However, the rebalancing may not have been the worst of it
for these investors. One can imagine the liquidity challenges
that may have been faced by investors who collateralized
equity derivatives with hedge fund exposure in the event
that the rapidly declining equity market exhausted their
initial liquidity reserves at the same time their underlying
hedge fund strategies suspended redemptions.
Nonetheless, although most portable alpha approaches
probably under-performed in September–November of 2008
(it is hard to imagine otherwise when virtually all assets underperformed
LIBOR), possibly resulting in under-performance for
the entire calendar year, the long-term value potential of many
different types of approaches, and the concept as a whole, is
still very real—and perhaps even stronger than ever in some
cases. That said, portable alpha is not necessarily universally
applicable and as straightforward as the example referencing
the S&P 500 futures implies, as liquid, cost-efficient derivatives
do not exist for all commonly referenced market indexes. The
broad bond market is perhaps the best example.
Bond Market Beta Replication: It’s Complicated
While a wide variety of liquid equity index derivatives are
available for use in portable alpha programs, there are fewer
liquid and/or low-cost options available for bond market
indexes. Historically, the total return swap market has not
offered reliable, low-cost replication of broad, multisector
bond indexes either. Similarly, at the time of this writing,
there is not a liquid futures contract on a broad multisector
index. So, for investors wishing to be long, for instance, the
Barclays Capital Aggregate Index via total return swaps, there
are very meaningful challenges in attempting to obtain that
index return precisely. The primary challenge is that broad
market bond indexes such as the Barclays Aggregate contain
an enormous quantity of bonds (the Barclays Aggregate
includes approximately 9,000 bonds).
Recognizing the challenges in exact replication of bond
indexes using derivatives, a number of innovative approaches
have been developed to facilitate synthetic (approximate)
replication of broad bond indexes using forward-settling liquid
instruments and liquid derivatives. While a thorough discussion
of the merits of such strategies is beyond the scope
of this article, worthy objectives are to provide meaningful
cost savings relative to expensive total return swap index
replication, not be reliant on any one counterparty for the
derivatives-based exposure, and to potentially deliver modest
performance improvements at the same time.
Fixed-income derivatives are oftentimes more liquid than
the underlying bonds, and in many cases offer opportunities
to generate a higher return. The good news for investors
seeking to replicate fixed-income indexes synthetically (with
minimal-to-moderate cash outlays) is that it is possible to
utilize a derivatives-based replication portfolio designed to
closely track the return of a broad fixed-income index. For
managers such as Pimco, this may be a natural extension of
efforts in core-plus-bond accounts.
Bonds As A Source Of Alpha
Retaining a focus on the fixed-income market, but looking
to the excess return or alpha side of the equation, high-quality
fixed-income strategies may be an excellent alpha source
when paired with higher-risk market exposures (i.e., equities,
commodities, etc.). The generally low correlation of highquality
fixed-income assets to higher-risk assets may result in
risk-reducing diversification. Higher-quality, diversified fixedincome
strategies may also impart important capital preservation
and liquidity characteristics along with structural return
advantages. Finally, compliments of the painful de-leveraging
and extreme market dislocation, high-quality fixed-income
yields outside of the Treasury sector are currently at extraordinary
levels by most measures—relative to history, relative to
LIBOR and relative to the apparent downside risk.
As was seen in 2008 and based on other periods of equity
market decline, high-quality segments of the bond market
have tended to perform relatively well. Looking across asset
classes and across investment strategies during periods of
financial market stress—for example, when the equity market
is experiencing a material price decline—many investments
exhibit a high correlation with equities. The exception
is often high-quality segments of the bond market, which
typically benefit from a flight to quality during such periods.
The end result may be capital preservation, liquidity and
the potential for excess returns when needed most. This
may serve in sharp contrast to portable alpha strategies that
often source alpha from riskier investment strategies that
may exhibit a materially high correlation with equities during
periods of equity market stress.
Importantly, unlike equities and other investments, from
an investor’s standpoint, bonds have the structural benefit of
eventually returning the capital invested (at par value) unless
the issuer defaults. Therefore, yield tends to be a reasonable
indicator of return over longer periods of time for high-quality
fixed-income investments and portfolios. While the shape of
the yield curve and yield spreads relative to money market
instruments may vary over time, the end result is higher
potential returns relative to money market rates across most
market environments. In today’s market environment, of
course, the levels of yield provided by even the highest-quality,
non-Treasury fixed-income securities are compelling.
Portable Alpha Is Alive And Well
2008 represented a noteworthy test of portable alpha
strategies, particularly for those employing lower-quality,
less liquid and/or leveraged investment strategies in the
alpha portfolio. The year also highlighted the importance of
counterparty, investment and operational risk management
of portable alpha programs.
continued on page 50
www.journalofindexes.com July/August 2009
37