By: Phyllis Feinberg, MARHedge
Published: August 14, 2006

This article (reprinted below with permission from the publisher, MARHedge) covers a number of recent portable alpha transactions from Pennsylvania Employees’ Retirement Fund and The World Bank to Iowa’s Public Employees’ Pension and the Desert States United Food and Commercial Workers Local 99.

Critics often charge that portable alpha is really all about picking good managers or hedge funds - that it’s All About Alpha.  Perhaps not surprisingly, Yoshiki Ohmura, lead manager of beta portfolios in GAM’s Portable Alpha Solutions group, points out that there is more to portable alpha that simply picking hot hedge fund managers.

“He (Ohmura) believes that a lot of people are focusing too much on the alpha, even though he says that having a stable source of alpha is key to the product. But it’s also important to look at your other components. In reality, the beta is going to be the volatile one. If you get that one wrong, you’re going to create much more damage to your product than on the alpha side.

Mellon and Citigroup are off and running, with GAM recently winning it’s first portable alpha mandate.  Let the games begin!

Full Text of Article…

Throughout the bull market of the late 1990s, institutional investors had no problems getting the investment returns they needed. But when the bear market started in 2000, that all changed.

“There’s been a paradigm shift in how investors are managing their money,” says Yoshiki Ohmura, who works for GAM Investment Management Ltd. in Zurich as the lead manager of the beta portfolios of GAM Portable Alpha Solutions.

Porting alpha

Investors are separating beta, market return, from alpha, absolute return, and are looking for ways to get alpha returns on their basic asset classes such as domestic equities or fixed-income investments. They want to move, or port, the alpha return; hence, portable alpha.

Hedge funds and funds of hedge funds are used to generate the alpha portion of portable alpha strategies.

“What we’re seeing,” says Ohmura, “is clients who have made investments into the hedge fund world already, choosing to move those positions into a portable alpha framework.

“They made the first step by deciding to sell down some traditional assets and buy hedge funds and now they’re going back and actually increasing their allocations to traditional markets by going into a portable alpha framework.”

Pension funds are among large investors now using portable alpha strategies. Pennsylvania State Employees’ Retirement System, International Paper, The World Bank and Desert States United Food and Commercial Workers Local 99 have all chosen to do this.

Others have portable alpha strategies in the pipeline. The Iowa Public Employees’ Retirement System plans to implement one by sometime next year, according to the fund’s chief investment officer Jeffrey Beismer.

A recent $25 million allocation from an Arizona-based pension fund was GAM’s first portable alpha mandate. The pension is using the GAM diversity strategy as the alpha component of the mandate and the S&P 500 index as the beta component.

Embracing the strategy

“There’s been a stable base of clients who have embraced portable alpha,” says Chris Cesare, a partner in Rocaton Investment Advisors in Norwalk, Connecticut, a consultant to pension funds. He says that a couple of years ago, most portable alpha mandates were part of pension funds’ large cap equity exposure, usually to the Standard & Poor’s 500 Index.

“Now they’re going into other asset classes, including fixed-income, international equity and small cap stocks,” says Cesare.

The $30 billion Pennsylvania State Employees’ Retirement System recently increased its portable alpha investments by more than $2 billion. The fund made its first portable alpha investments in 2002, when it used them to increase the return on its domestic large cap equity investments.

The fund used S&P 500 swap contracts to maintain market exposure to large cap stocks, while investing in broadly diversified funds of hedge funds to obtain additional returns.

That program produced total earnings after fees 4.5% greater than they would have been if the fund had invested only in the S&P 500. “Our portable alpha strategy has added about $780 million in net earnings to date, without materially increasing the portfolio’s overall risk,” says SERS board chairman Nicholas Maiale.

“That success led the investment office to recommend, and the board to approve, greater exposure to portable alpha.”

Penn SERS’ new mandates

The new portable alpha mandates that Penn SERS recently made include the international equity asset class. It hired two funds of hedge funds, New York-based Arden Asset Management LLC and The Rock Creek Group in Washington, DC, to initially manage approximately $650 million in low-volatility nondirectional funds. Exposure to international stock markets will be achieved through EAFE (Europe, Australia, Far East) Index swaps.

Mark Billings, director of Pasadena, California-based First Quadrant LP, which recently won a $200 million global macro portable alpha mandate from Penn SERS, says endowments such as Harvard’s and Princeton’s have been doing portable alpha investments for years and that pension funds are now catching up.

Billings says that there is “an enormous percent of applicable beta strategies” that can be used in portable alpha products, so investors can get exposure to almost any asset class through these investments.

Citi’s strategy

Citigroup Alternative Investments in New York has developed a portable alpha product that offers 40 strategies. “We have a very broad set of what I would call alpha pools, so we can draw very broadly on a number of areas; a lot of uncorrelated markets that will let us construct what we think is a better mousetrap,” says Neil Brown, managing director of CAI.

“We think that the limitations of the existing solutions that are provided to pension funds tend to be that they are either a very small number of alpha sources, they rely on either market neutral hedge funds or a very static view of what the market exposure is of the manager,” says Brown.

The product is then constructed on that basis and is then managed, he says. “So we’ve developed all these analytical tools to help us do that so that when we come along to a pension fund we can take this platform and say, ‘Here’s the methodology, look under the hood.’

“And because we have a number of alpha sources ourselves—north of 40—we can construct a portfolio to fit the requirements of a pension fund. In fact, we’ve just been working with a client this week, literally tailoring a set of five portfolios for them to have a look at.”

In terms of the beta portion of the product, “we can port this platform on to any benchmark the client wants,” says Brown. “We’ve constructed deliberately to be able to be ported onto anything. We’ve pulled out the alpha completely. And part of the very proposition for the platform is that we can manage the relative beta exposures because we have very sophisticated models to do that.”

Two approaches

According to Ohmura, “there are basically two approaches to portable alpha; one is where the alpha provider is structuring a portable alpha product. The only problem is that their expertise lies in selecting hedge funds or building funds of funds.

“They don’t really have any expertise in managing derivative portfolios—from a trading perspective, an operational perspective or a risk management perspective—and therefore the solutions are pretty static.”

He says the other major portable alpha model is that of investment banks offering products that they structure. “Most investment banking solutions are structured in the form of notes or in the form of swaps that cover all the assets, so in essence the client carries counterparty risk on every dollar they invest,” says Ohmura.

“They put one dollar in and they get a note from a bank, telling them that they have 100% counterparty risk on that dollar with the bank.”

GAM’s product is set up so “we have a fund and that fund buys assets which are hedge fund assets, but the fund actually owns those assets,” he says.

“The fund actually retains those assets for the client and the only counterparty risk that the fund has is on the total return of the index—of the beta—that we diversify additionally by having multiple counterparties. So we significantly reduce the counterparty risk in our solutions, versus what we’re seeing from other investment banks.”

Ohmura says that a lot of investors who have made allocations to portable alpha or who are looking to make allocations “don’t really look into the structures themselves. And this is where they’ll get tripped up. Because superficially portable alpha is all the same; you have some alpha and some beta and you put it together. A lot of people are looking at that.”

He believes that “a lot of people are focusing too much on the alpha,” even though he says that having a stable source of alpha is “key” to the product. “But it’s also important to look at your other components.

“In reality, the beta is going to be the volatile one. If you get that one wrong, you’re going to create much more damage to your product than on the alpha side.”

He thinks many people are neglecting that aspect. “So if you go and dig down to the nuts and bolts of things, the portable alpha solutions may well be very, very different in how they’re set up, and it’s really about reading the fine print and looking at how they’re structured.”

Mellon’s methods

Pittsburgh-based Mellon Capital Management Corp recently received $1 billion in mandates for its International Equity Alpha Plus strategy, its third global portable alpha product, introduced this year. The strategy is designed to outperform the EAFE index.

The product combines traditional exposure to the international equity index with Mellon Capital’s global tactical asset allocation strategy, which takes long and short positions in global equity, sovereign bonds and currency markets.

The strategy seeks to generate returns that consistently exceed the market-based benchmark through an investment approach that results in excess returns that have low correlation to traditional markets.

Thomas Hazuka, a managing director of Mellon, says that the firm’s other portable alpha products include one with a cash benchmark in which the money is invested in bank commingled funds and one with a fixed-income benchmark.

“The alpha can be ported over any benchmark the investor wants,” says Hazuka, adding that Mellon will soon offer other portable alpha strategies.

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