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.

This leaves the plan in the uncomfortable position of having to explain how it lost money on “derivatives investments” - as if the swaps were a stand-alone investment strategy or an out-right market call.  But they were not.  The loss on the swaps is analogous to the market losses experienced by any other plan that invested in equity markets the usual (fully-funded) way.  The real trouble seems to have resulted from a surprise in the performance of the “absolute return” portion of the portfolio, not the swaps.  As a spokesman for the plan told P&I,

“The losses were not because of the use of swaps per se, but because (underlying) equity markets are down.”

In theory, the absolute return investments should have had a very low (ideally a zero) market correlation and a modestly positive long-run return.  Thus, the combination of the market-tracking swaps and the absolute return funds should have produced returns equal to the market plus a bit of icing.

But many hedge fund strategies - including the funds of funds used in this particular portfolio - seemed to mimic equity markets in Q3.  In other words, they seem to have contained a hidden market exposure that was only revealed in times of distress.  The result was that Penn SERS seemed to have an excess exposure to markets (100% exposure, for example, in the swaps and an additional, x% exposure via the supposedly “uncorrelated” hedge funds of funds).

But hedge funds’ surprisingly large correlation to equity markets in Q3 does not, on its own, repudiate portable alpha as a portfolio construction technique.  As we mentioned after August 2007’s quant drawdown, a zero correlation does not mean that the fund and the market are immune to concurrent drawdowns.  While a perfectly stable monthly return (i.e. cash) has a low (zero) market correlation, so can a more volatile hedge fund.  The hedge fund, in theory, produces intermittent monthly drawdowns that are simply unrelated to those of the market.  The key is that “unrelated” means they can easily be negative when the market is also negative.

Here’s an example of two randomly generated return streams with a zero correlation over 30 months.  Both return streams have an 11bps average monthly return and have very similar standard deviations.  Note that despite their zero correlation, their signs are the same half the time.

In four of the thirty months, both funds have a significantly negative return.  Yet such a combination remains a viable portable alpha solution since, over the long run, you never really know what one fund will do based on the returns of the other.

This is a simple illustration only.  The actual “absolute return” funds used by SERS may have had a significant positive market correlation over many months or years.  If so, then one might expect the amount invested in the market-replicating swap to account for this.  (We have no more information than what has been reported in the media and by SERS.)

The Massachusetts Pension Reserve Investment Trust (PRIT), another fund reporting a recent loss in its portable alpha program, pins the blame on the investments selected for the program, not on the concept itself.  Its Executive Director told Dow Jones last week:

“Over the short period of time [that it’s been used], it’s not performed well…But we think that’s more a reflection of market conditions. We’re not thinking of scrapping portable alpha.”

And the WSJ reports that Penn SERS’ portable alpha program remains in the black since inception:

“[Pennsylvania SERS] officials say that, even with that setback, the strategy has generated $500 million in cumulative above-market returns.”

So the bottom line seems to be that portable alpha strategies, like 130/30 strategies, are only as good as the raw materials used to construct them.  The reported “failure” of SERS and PRIT programs may offer some important lessons, but they will likely not end the debate over portable alpha.

Okay.  So the truth is out, hedge funds have long equity exposure.  Our back-of-the-envelope analysis of the HFRI Index last week showed that all strategies - particularly “Equity Hedge” had a positive correlation with equity markets.

So what can an investor seeking truly uncorrelated returns do about this?  After all, it’s quite possible that a hedge fund could produce alpha, but deliver it to investors with a side helping of over-priced beta.  Short bias managers, for example, are often said to produce a positive alpha even though they lose their shorts year after year.  It’s cases like this that make the term “absolute returns” a misnomer (see related post).

A new paper by the Edhec Risk and Asset Management Research Centre illustrates the ways that a fund of hedge funds can mitigate itself from these not-so-hidden factor exposures.

To begin with there’s that pesky equity exposure.  The following graph from the report shows the contribution of the MSCI World (blue line) to the volatility of the HFRI Fund of Funds Index:

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Is the quest for alpha a religion?  In some ways, it just might.  This according to The Economist last week.  Says the magazine (sorry, “newspaper”):

“The concept of alpha is a slightly metaphysical one and resembles the “God of the gaps” familiar to Victorians. Traditionally, people were inclined to attribute natural phenomena such as earthquakes and plagues to God; eventually they discovered plate tectonics and bacteria. The role of God was steadily diminished to that which people could not explain by other means.”

Separating the secular (beta) from the spiritual (alpha) has been the mantra not only of liberal democracies, but also of a new breed of investor.  Hedge funds find themselves at the center of this metaphysical revolution, not because they simply aim to make “absolute returns”, but because they (claim to) have taken a vow of beta-celibacy.  Continued The Economist:

“In a way, hedge funds, by virtue of their complex strategies, are one of the main perceived repositories of alpha left in the market (the average traditional fund underperforms the market, after fees).”

In an attempt to repent for their historical portfolio management sins, institutional investors such as pension funds aren’t just looking to hedge funds for short term gratification, but they are looking to them for something deeper - something to balance out the day to day ups and downs of beta.

Unlike many traditional religions, the alpha-centric religion is flourishing in both North America and in Europe.  Citywire, a London-based online publication wrote in August:

“The latest trends in the European investment industry show that the separation of the fund market into an alpha world (active management) and a beta world (index funds and ETFs) is a reality.”

Meanwhile in the US, Wall Street & Technology wrote around the same time that:

“…the separation of alpha and beta is a critical growth driver of the alternative investment industry in general and hedge funds in particular.”

The magazine provided the following chart to illustrate why the preferences and objectives of institutional investors were so critical to the future of the hedge fund industry:

But a higher plane of being may prove somewhat elusive to some members of the monastic order of alpha seekers.  Consultancy Celent observed just last week that:

“Alpha/beta bifurcation and greater levels of competition have made alpha generation an increasingly difficult proposition for hedge funds.”

Hedge funds might seem like a kind of fringe cult to many mainstream traditional investors.  But while their unconventional approaches may sometimes seem unorthodox, their objectives are really no different than those of all other active investments - alpha.

Axing investment managers is nothing new for institutional investors.  So initially we didn’t see anything particularly interesting about this story in P&I about how the pension fund for Massachusetts teachers and public employees was dumping a few of its underperforming managers.

But when we took a closer look, it was apparent that something else was at play here.  P&I reports that this move was actually a “strategic shift in the $50.6 billion system’s domestic equity program to index funds and portable alpha”. In other words: a shift out of traditional “pre-packaged” alpha and beta and into a bifurcated alpha/beta program.

A third of the freed-up capital was immediately reallocated to three portable alpha managers and two-thirds was destined for an index fund.

But the story gets even more interesting.  Bridgewater, a company we applauded for not messing around when it came to portable alpha, was actually fired in the shake-up.  Why?  Remember a couple of years ago when we told you about the firm’s plan to drop clients that didn’t want to move to a portable alpha strategy?  Well, apparently, Mass PRIM let them do just that.  According to P&I, the pension said “no way” to a pure alpha mandate and it promptly showed Bridgewater the door…

“Bridgewater Associates, which ran $591 million in global inflation-linked bonds, including an allocation to commodities via swaps, was terminated after the board rejected its request to change the portfolio to a pure alpha strategy. Bridgewater’s offer to wind it down over the coming 12 months was turned down; Mr. Mavromates said PRIM decided it didn’t want someone who wasn’t interested in managing the strategy over the long term to look after it for the coming year.”

It appears Bridgewater’s Ray Dalio wasn’t kidding.

With its (appropriate) focus on generating returns, the asset management industry tends not to spend inordinate amounts of time on introspection - on the way firms in the industry management and organize themselves.  As management consults are fond of saying “form follows function”.  That’s consulting-speak for “structure follows strategy”.

A great example of an organization that realizes the holistic implications of alpha/beta separation is Sweden’s AP7, one of the country’s many so-called “buffer funds” designed to fund the retirements of its citizens.  Regular readers may recall AP7 and its forward-thinking CIO Richard Grottheim.  As we reported in January, AP7 has recently awarded what it calls “pure alpha briefs” that are essentially notional overlays applied to the fund’s passive portfolio.

A few weeks ago, Grottheim and colleagues including one from the Stockholm School of Economics, revealed how AP7 is set up to undertake this kind of innovation in a new white paper.  In this paper, Grottheim and friends propose an org. structure that they say shows “not only significant improvement in portfolio performance, but also a more transparent and cost efficient portfolio structure.”

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We report today from a three-day London gathering of some of the world’s largest institutional investors and the hedge funds that serve them (see postings from sister event in Boston last fall).  The event focuses not on hedge funds per se, but on how institutional investors use them (portable alpha, fees, alpha/beta separation, 130/30, alternative beta, analytics etc…all the good stuff).  In order to create an open atmosphere for candid discussion, organizers have us on a tight leash (there are otherwise no media present here and we can’t even tell you the name of the event).  And while we can’t really tell you who said what today, we can pass along some of the major themes from the conference floor.  Here’s some of what we heard…

Hedge Funds: Innovation from the garage?

After years of steady growth, it’s no surprise that traditional long-only money managers have been licking their chops over the potential to offer hedge funds.  Meanwhile, hedge funds have been strangely attracted to the gazillions of dollars under management by the long-only managers.  Today in London, managers and investors debated the relative merits, not of hedge funds and long-only funds, but of hedge fund management companies and long-only management companies.  While many people can tell you the difference between a hedge fund and a traditional long-only fund, few seem to agree on the unique characteristics of each type of company.

Most here held the opinion that hedge funds was no longer a useful definition of an asset class.  One panellist put it in terms of innovation.  He described hedge fund companies as a platform for innovation.  In an allusion to innovation in the technology sector, he said that innovation usually happens in garages, not in large corporations (a clear reference to the oft-cited garage where tech behemoth Hewlett Packard was born - pictured above).  In other words, it may be difficult for a large traditional manager to deliver on the major promise of the hedge fund sector - innovation.   Issues such as profit- (and risk-) sharing, for example, can often confound the efforts of long-only managers (e.g. banks – see related WSJ piece from last week) to maintain hedge fund programs over the long term.

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Watson Wyatt consultant Janet Rabovsky passes along an interesting observation from a recent Watson Wyatt global “research summit”, a biannual affair for those involved with manager research at the firm.  

Apparently, Thomas Friedman’s seminal book “The World is Flat” has a lot to say about the current state of asset management.  Writes Rabovsky:   

“…Another key theme of Friedman’s book is the separation of value-adding activities from commoditized activities. He says: ‘more and more jobs will be broken apart, with the more sophisticated tasks being done in the developed world and the less sophisticated tasks being done in the developing world—where each has its comparative advantage.’ Many companies have already embarked along this path, including my own. Research is done in Uruguay and Bangalore (for North America and Asia respectively), while data processing is done in the Philippines and Mexico City.

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PIMCO’s Chris Dialynas knows portable alpha.  In fact, commentators such as author Peter Bernstein generally agree that PIMCO essentially invented portable alpha back in the 1980s in the form of the firm’s “StocksPLUS” and “BondsPLUS” products (see related posting). 

Dialynas joined PIMCO way back in 1980 - surely before several of PIMCO’s current junior analysts were even born.  So when he cautions the world about the movement he helped create, we’re probably best served by listening closely to what he has to say. 

He is the author of the epilogue to the new book “Portable Alpha Theory and Practice” by Sabrina Callin (see related posting).  The chapter is ominously titled “Portable Alpha - The Final Chapter: Schemes, Dreams, and Financial Imbalances: ‘There Must Be More Money’” and it amounts to something of a sanity check on the current state of portable alpha.  The entire chapter can be downloaded here at AllAboutAlpha.com.

While cautious, Dialynas doesn’t actually question the underlying rationale behind alpha-beta separation or portable alpha itself.  Instead, he expresses his concern that the techniques often used to create or isolate pure alpha (leverage and derivatives for example) have led to unacceptable risks to the financial system (think: Richard Bookstaber’s “Demons of Our Own Design” - see related posting).  

Says Dialynas:

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In December, we told you about plans for a new series of mutual funds constructed by combining active and passive components (see posting).  Boston-based FundQuest had always been content to provide the plumbing for the mutual fund industry - manager selection, back office support, marketing services and sales support to financial advisors.  But the firm announced last week that it has finally launched its first mutual fund based on these ideas- called ”ActivePassive Portfolios” (see sales brochure). 

While this sounds like an oxymoron, it’s a great example of alpha/beta separation extending slowly, but surely, into the retail marketplace.  As a sort of pre-packaged alpha-beta solution, it reminds us of the Janus institutional offering launched last year (see related posting). 

Here’s what they say about the “optimal” ratio for the offering:

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The term “portable alpha” is still a relatively new addition to the popular lexicon.  As we’ve written on these pages, the term itself seems to morph on a regular basis to encapsulate the literal “porting” of alpha between asset classes to the combination of hedge funds and swaps.  Issues like active management fees, regulation, risk measurement, and market efficiency seem to weave their way in and out of the various definitions of portable alpha.

Now someone has finally brought many of these concepts together in one place.  “Portable Alpha: Theory and Practice” (US link) edited by PIMCO’s Sabrina Callin has just hit bookstores.  If you read Peter Bernstein’s “Capital Ideas Evolving” (see related posting), you may recall that PIMCO is considered to be one of the early pioneers in portable alpha strategies.

Naturally, we’re working our way through it right now and are so far impressed with the holistic nature of the content (including contributions by Rob Arnott, Bill Gross and several PIMCO managers).

Yesterday, AAA media partner HedgeWorld ran an interview with Callin for its premium subscribers.  With permission from our friends at HedgeWorld, we have re-printed the interview in its entirety below.

But before you read the interview, here’s a quick footnote.  It appears that Portable Alpha has a lot of fans in the UK and Singapore.  A Google search of this book returns the publisher’s country-specific websites in the following order: UK, Singapore, US, Germany, Canada.  A flagrantly un-scientific observation for sure.  But curious nonetheless…

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Pennsylvania is not only the latest battleground between the Democratic presidential contenders, it’s also one the biggest battleground between traditional long-only investing and alternative investments.

The AP reports that the Pennsylvania State Employees Retirement System has been getting a lot of fan mail after it announced a 17% return last year.  Reports AP:

“The secret? Diversifying away from the staid, plain-vanilla investments historically made by public funds, such as buying and holding big chunks of U.S. stocks and bonds. Concentrating money in domestic holdings makes the pension greatly susceptible to the swings of the U.S. market. Instead, performance was powered by alternative investments such as venture capital and funds of hedge funds, using complex strategies such as portable alpha and absolute return—a path long blazed by endowments.”

John Winchester, the plan’s CIO, tells AP that his goal is to “whether a variety of different market environments”.  It appears he may stick with the nearly 25% allocation to hedge funds and private equity for some time. As the AP points out:

“Looking ahead, Winchester sees a volatile stock market throughout the year because he doesn’t believe blowups from the housing crisis are over.

“‘There’s a way to go before things settle down,’ he said.”

The SERS website breaks down the numbers:

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Regular readers will remember that in 2007, portable alpha and 130/30 were deemed to be “up and coming” by management consultancy Casey Quirk & Associates (see related posting).  The firm surveyed 49 North American investment consulting firms and found that portable alpha, liability-driven investing and 130/30 “may not represent a search focus, but see rising interest in conducting search activity.”   

Casey Quirk just released the results of its 2008 survey.  And this new edition concludes that 130/30 and LDI remain “up and coming”, but portable alpha has been told to clear out its desk and move to “low opportunity” with commodities and fixed income.  (”Low opportunity” is defined by the report as any asset class “faced with declining interest and little focus from the consultants in 2008.”)

Here is how Casey Quirk saw the world back in March 2007…

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Yesterday, we mentioned an unreleased academic study that measured the aggregate “cost of active management” in US equity markets.  We concluded with remarks from one particularly staunch proponent of efficient markets.  But even he left the door open for active management (presumably where markets were less efficient).

Assembling such an active/passive portfolio lies at the heart of alpha/beta separation.  But since the term “alpha beta separation” conjures up memories of high school math club, marketers of asset management services have coined the term “core/satellite” investing (where “core”=passive and “satellite”=active).  What’s striking is that, rather than being ridiculed by traditional passive managers, core satellite is being embraced by them.

For example, this brochure from Barclays (iShares) is subtitled “creating harmony between index and active strategies”.  It says:

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Bloomberg Columnist Michael Sesit warned last week that mutual funds and hedge funds better watch out for an invasion by ETFs.  He quotes one expert as describing ETFs as “The Blob” from the 50’s sci-fi movie that consumes everything its in path.

He picks up on a theme espoused by his late colleague, Chet Currier in a December 2006 column on how mutual funds may someday become “obsolete”, when he observes:

“To some degree, index-linked products are already eating active managers’ collective lunch. Based on the almost $1 trillion invested in index-based products in the U.S. — up 2,610 percent since 1993 — the active-management community is losing about $12 billion a year in management fees, [Adam] Sussman [of the Tabb Group] says.”

But throughout the column he paints hedge funds with the same brush:

“Lower expenses, the failure of most active-mutual fund managers to beat their benchmarks, the growing number of thematic and specialty ETFs, and the funds’ flexibility suggest they will attract investment that otherwise would flow to actively managed mutual and hedge funds.”

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