Earlier in the week, we told you about a great 100 page “mini-book” on alpha/beta separation.  The authors (Analytic Investors’ Roger Clarke & Harindra de Silva and Brigham Young University’s Steven Thorley) provide a clear and cogent argument for why you’d want to separate and re-proportion the active and passive components embedded in any actively-managed investment mandate.

While the generic case outlined in the document involves a traditional long-only active fund, the authors also explore the potential role of hedge funds in alpha/beta separation.  They point out that despite the popular assumption that hedge fund returns are nearly all alpha, this is “only partially true” in aggregate.

Hedge Funds not all about alpha – Just mostly about alpha

The following table shows the average proportion of risk derived from alpha and beta across  arbitrarily-selected hedge fund strategies: More…

It seems that after losing their shirts in equity beta, a surfeit of pension funds are now swearing off portable alpha strategies.  Late last year, we discussed how the Pennsylvania State Employees Retirement System (SERS) had taken an equity bath during 2008.  And Pensions & Investments reports this week on two other major public plans – in Massachusetts and Colorado – that have opted to call it day when it comes to portable alpha.  Even the mythical California Public Employees Retirement System (CalPERS) has recently decided to wrap up its portable alpha program (Ed: Great reporting in these P&I pieces btw.  Well worth a read.)

This website was launched just as the notion of alpha/beta separation was beginning  to take hold.  Over the past 3 years, we have advocated for the delineation of alpha and beta, both conceptually (in a portfolio and fee analysis context) and literally (as in portable alpha programs).  By virtue of their focus on alpha-centric returns, alternative investment strategies such as hedge funds were a natural source for the alpha-centric portion of these strategies.

Unfortunately, the term “portable alpha” quickly became synonymous with hedge funds themselves.  Generally, when someone asked whether a fund has adopted a portable alpha strategy, they really meant to ask if the fund had invested in hedge funds.

Portable alpha strategies, however, were simply a flexible construct that combined hedge funds and market (beta) in a form that loosely approximated traditional active management.

Proponents of hedge funds argued that investors should forsake beta entirely and invest solely in alpha-centric hedge funds.  Opponents charged that hedge funds were a mugs game and that beta was proven commodity.

So it may come as no surprise to critics of hedge funds that portable alpha has lost its luster.  But what may come as a surprise to them is the fact that it was traditional market beta, not the hedge funds, that led to its apparent undoing.

“Portable Alpha” is dead – long live portable alpha!

As P&I reports, Massachusetts Public Reserves Investment Management Board (Mass PRIM) and the Fire and Police Pension Association of Colorado both lost their shirts on the beta portion of their portable alpha strategies.  In fact, the newspaper reports that the Colorado plan is actually looking to double its current allocation to absolute return strategies.

While dumping its portable alpha approach, Mass PRIM will still be maintaining its absolute return allocation at current levels – splitting it between its existing hedge fund bucket and its global equity bucket.  Similarly, Pennsylvania SERS has “dismantled” its portable alpha program, but actually created a whole new investment category for its existing absolute return allocation.

The Real Culprit: Beta

These moves highlight the fact that portable alpha can be looked at two ways: as an alpha overlay on a beta (traditional) allocation or as a beta overlay on an alpha (absolute return) allocation.   To its credit, CalPERS seems to view things the second way, as a beta overlay on its absolute return allocation.  Reports P&I:

“CalPERS doesn’t have a portable-alpha program, at least officially. But sources said the beta overlay run on top of the Risk Managed Absolute Return Strategies portfolio produced the dismal results similar to portable-alpha programs employed by other institutional investors.”

It seems that the CalPERS beta overlay was implemented to prevent the overall pension fund returns from diverging too much from the benchmark index.

Unfortunately, it succeeded.  Despite positive returns for the fund’s alternative investments bucket, the beta overlay simply ensured that California’s public employees were subsequently impoverished just like the rest of us.

According to P&I, CalPERS added its beta overlay in response to “performance drag” between 2003 and 2007 as the market shot upwards.  By May 2008, after watching equity beta make everyone rich, they finally gave in and hitched their wagon to the markets by shoring up its beta exposure.  Not the best timing for sure.

Here’s how the plan’s general consultant, Wilshire Associates described the situation to the plan’s CIO Joseph Dear in an August 2009 report for the board:

“Staff began adding a beta (market exposure) overlay to the RM ARS [Risk Managed Absolute Return Strategies] program a few years ago. Despite RM ARS relatively strong performance versus its benchmark, RM ARS underperformed the broad stock market from 2003 to 2007. As a result, RM ARS was a drag on the returns of the total of Global Equities versus a market benchmark…

…If such an overlay is not desired, then the Investment Committee may wish to exclude RM ARS from the performance of the Global Equity composite…”

The report included the following table showing just how badly the alpha-centric program was beaten down by the beta overlay (click to enlarge):

A Market Call?

So does this suggest that portable alpha may have been a market timing strategy all along?   Not necessarily.  But the separation of alpha and beta decision-making does provide investors with new tools to shoot themselves in the foot.  And that seems to have happened in California, Massachusetts, Colorado, Pennsylvania and countless other public pension funds.

In the end, the absolute return inspired proponents of portable alpha may have had the last laugh.  While portable alpha seems to be on its death bed, alpha-centric investing seems to be alive and well.

Alpha? ...Or polished beta?

“Core-satellite” investing is often regarded as a precursor to portable alpha and various other modern portfolio construction techniques.  However, the popular definition of the term usually refers to a passive “core” and an active “satellite”.  And as we have argued extensively on these pages, active management too often contains a large amount of embedded beta.  Ideally, in our view, core-satellite would involve a beta core and a (pure-) alpha satellite.

This is essentially the same argument presented in a recent paper by Swiss researchers called “What if alpha is just polished beta?“.  The study was authored by Erik Wallerstein, Nils Tuchschmid & Sassan Zaker – the authors behind a paper we covered last week on the performance of hedge fund replication products.

The trio question whether funds of hedge funds should even be in the high-alpha “satellite” allocation in the first place.  They reason that if funds of funds can be replicated passively, then they should be disqualified from being satellites and should instead be treated as part of the core (beta) portfolio.

They use a simple linear model with 5 factors (the Russell 2000, the MSCI EAFE, the Barclays Agg, the GSCI and the CBOE S&P 500 BuyWrite Index) to replicate the HFRI FoF index.  As you might guess, they find this to be the case.  In fact, check out the tiny tracking error of this simple model (click to enlarge): More…

Despite being maligned as financial alchemy, alpha/beta separation refuses to die (probably because it’s a good idea, but we’re biased).  For example, Carl Hess, Watson Wyatt’s Global Head of Investment consulting said in a press release last week:

“As we move into a different and difficult market environment, we expect there will be more rapid developments around some emerging trends. One notable theme is transparency, particularly the separate identification of alpha and beta, as well as an increased focus on risk, both from investors and managers alike.”

Hess isn’t talking about exotic investment strategies or screwy derivatives contracts.  He’s simply referring to the fact that investors should be buying alpha and beta separately, not mashed together.  Apparently institutional investors agree.

In this recent Journal of Indexes article on alpha/beta separation, Robert Whitelaw, Salvatore Bruno and Anthony Davidow write: More…

Linear regression models (a.k.a. factor models) have a number of emerging applications in the hedge fund industry.  One of the most often-cited here and elsewhere is hedge fund replication (see related posts).  But as we discovered recently, regression-based models can also be used to estimate the daily returns occurring between monthly hedge fund reporting cycles (see related post).  In addition, MIT’s Andrew Lo has proposed several other applications of linear factors models to address situations such as transitioning between managers and portfolio rebalancing for risk management purposes (see related post).

Now Lo has teamed up with Alexander Healy of Alpha Simplex Group (the company with which Lo is closely affiliated) and proposed yet another application of this truly alpha-centric approach to portfolio management: dealing with redemption gates.

The two suggest that when hedge fund investors are confronted with redemption gates, they can essentially remove their economic exposure to many of the underlying hedge fund betas in much the same way an executive can monetize un-vested stock options.  By basically shorting the basket of betas that make up the returns of lock-up hedge fund allocations, investors can reduce volatility dramatically and in some cases, even increase returns (i.e., if the alternative betas in question temporarily deliver negative risk premia).

Drawing on a knack for colourful metaphors, Lo says this is not unlike the strategy taken by the drugs often prescribed to those with high blood pressure: More…

Although the mainstream financial media now routinely ridicules “exotic” investment strategies such as portable alpha, institutional interest in managing alpha and beta separately has not gone away.  As we have reported on these pages, portable alpha strategies performed poorly in 2008 not because there was anything wrong with the concept, but because the supposedly-uncorrelated alpha sources happened to keel over and die along with the market.  As a result, portable alpha investors lost money on the beta side and the alpha side.

Sophisticated investors are well aware that the real culprit was the questionable uncorrelation of the funds of funds often used as an alpha source – not portable alpha per se.  An interesting paper by Rob Brown of Benchmark Plus Management makes the case that portable alpha will experience a “rebirth” and will eventually become “dominant” and “commonplace”.  (available here in P&I’s white paper library)

Writes Brown: More…

On November 25, the Pennsylvania State Employees Retirement System (SERS) announced its Q3 results.  Public pensions across the US issued similar press releases detailing the Q3 carnage.  But what makes this pension plan different is its widely publicized use of portable alpha (see our April 2008 post.)  As a result, the media has been quick to associate the fund’s losses with the “aggressive“, “exotic” and “unusual” investment strategy.  To be sure, it appears that portable alpha cost the plan in Q3.  But is that an indictment of the portable alpha architecture per se?  We’re not so sure.

The Wall Street Journal reports that:

“The blowup is yet another example of the wide-ranging damage caused by sophisticated investment strategies peddled to pension funds and other institutional investors when the stock market was soaring.”

Pennsylvania SERS reportedly lost $1.5 billion on swaps used to gain market exposure.  These swaps allowed the plan to get the exposure it wanted without having to allocate as much capital (i.e. it only had to post margin on the swaps).  It then invested the savings in “absolute return” funds (funds of hedge funds in this case).  According to media reports and the plan’s own press release, it appears that it lost on both the swaps AND the absolute return funds in Q3.

More…