By: Lex Huberts, Standish Mellon Asset Management
Published: Fall 2004, Journal of Investing

This paper does an excellent job of covering the many flavours of alpha-centric investing.  It also provides a number of hypothetical mathematical examples of portable alpha. Including the following:

“Suppose a plan has a very talented Japanese stock selector who is considered very likely to outperform the local market. What if the plan likes the manager’s skill, but is leery about the prospects for Japanese equities in general? To reduce risk or to express a negative opinion on the Japanese equity market, derivatives can be used to eliminate the systematic equity or currency exposures through the short sale of futures and forwards. Currency hedging programs are more common, but the equity exposure may be eliminated just as easily.”

Importantly, Huberts does not necessarily advocate the use of market neutral hedge funds per se.  Instead, he positions hedge funds as simply a subset of portable alpha.  He suggests that an “absolute return” manager need only short their benchmark to earn that designation.  Of course, doing so provides no potential for alpha from short positions.  So he introduces hedge funds as one possibility…

“Long-short equity strategies are fully funded accounts that invest in equities but also borrow and sell (short) other physical equities. If the long positions are equal in size to the borrowed position, there is no systematic equity market exposure. This is another incarnation of the absolute return concept.”

But back to the Japanese long-only manager who simply shorted the Nikkei.  Huberts shows how the resulting alpha can be “transported to the S&P500…

Alpha Transport is just combining the Japanese alpha with S&P500 The absolute return strategy may be complemented with the creation of new exposure to risky asset classes. In an additional step, the advisor may purchase S&P 500 futures contracts to obtain U.S. equity exposure.”

This is where Alpha Male has issues.  Isn’t this all semantics?  What difference does porting it make?  In fact, the manager has just added a short Nikkei/Long S&P500 trade on top of their active fund - hence the name “overlay”.  (see posting from Business Week for a very similar srategy under the banner “How to Build Your Own Hedge Fund”).  “Porting” alpha is really just a show for the client’s investment committee.  It satisfied their fiduciary responsibility to maintain a (probably quite conservative) policy mix….

“The short position in Japanese equity futures and the long position in U.S. equity futures are not taken to express a view on these asset classes, but rather to move asset class exposures back to a neutral policy mix.”

While this article makes reference to market neutral index-overlays, it does not specifically discuss market-neutral equity overlays such as the one used by the Canadian Pension Plan (see post).  Still, concepts such as the “notional amount” are critical to both forms of overlays…

“One common way to curtail exposures involves the use of acceptable over- and underweights (ranges) applied to an agreed-upon notional amount. The notional amount of the mandate together with other risk control parameters will determine the size of positions the manager can take. The notional amount could be set equal to the total plan value of $2,000 million. Alternatively, it would be perfectly reasonable if the overlay manager agreed to manage to a predetermined notional amount, of for example, $500 million, supported by $50 million in cash transferred.”

Read Full Article (Free 14-day Subscription Required)
(alternatively, visit Mellon’s Australian Website to order a free copy)