Portable Alpha: Divorce and Remarriage Alpha and Beta

The concept of portable alpha is over 40 years old. And while it has evolved through various forms over time, it continues to be a valuable portfolio tool for institutional investors. Probably the most popular iteration right now is adding alpha expected from hedge funds in addition to synthetic beta exposure. Hedge funds represent alpha, while beta is comprised of broad index derivatives such as futures or total return swaps. This combination has been a powerful alternative to finding consistent, alpha-generating, long-term managers. The strategy is most successful when the hedge fund portfolio is expected to consistently outperform the cash rate and beta is implemented in a capital and cost efficient manner.

Let’s walk through an example to highlight some considerations for implementing a portable alpha strategy.

Suppose an institutional investor builds his hedge fund portfolio at $1 billion, expressing his belief that such mandates have high potential to generate alpha. The allocation will consist of market neutral (or absolute return) mandates that are expected to outperform cash by a few percentage points. To get cash for hedge fund investments, they will redeem from their passive equity (or fixed income) funds and replace the beta with derivatives managed by an overlay provider. Finally, a small portion of redemptions will be in cash to support derivatives rather than invested in hedge funds.

Figure 1

Here are some considerations:

1. Beta selection

Equity beta: Equity beta can take a variety of forms (eg S&P 500, MSCI World, MSCI ACWI IMI). Synthetic beta is most commonly in the form of stock futures. However, depending on factors such as portfolio size, investment horizon, index selection and investor account documentation (to allow over-the-counter trading), a combination of futures and total return swaps may be appropriate (to see Figure 2). When a combination is used, swaps tend to serve as the underlying position, while futures will be smaller but more nimble positions that can easily be adjusted up or down in accordance with changes in valuation. of the underlying hedge funds. While most portable alpha strategies rely solely on beta derivatives, incorporating a fully funded physical allocation (eg ETFs or a custom basket of physical securities) can be a good strategy to lower the overall cost of implementation when derivatives are valued at a premium. A cost/benefit analysis can be performed to find the optimal level of physical and derivative elements. The implementation of T+1 regulation in the US has made this more of a possibility.

Figure 2: Example of stock beta

Beta with fixed income: Some institutions prefer a beta component with lower projected volatility than equities. Others may be more interested in the diversification benefits of fixed income beta – especially in cases where the portfolio’s overall allocation to underlying fixed income is low. To replicate fixed income beta, a combination of government bond futures, credit default swaps (CDX), and total return swaps can be an effective strategy. These customers also tend to value the lower warranty requirements needed to support the portable alpha program.

Figure 3: Fixed income beta example

2. Collateral

A pool of collateral must be established to meet initial margin requirements for derivatives and daily gains and losses. A good rule of thumb is to allocate 10-20% of your total notional amount – closer to 10% for fixed income and more than 20% for equity. Initial margin requirements vary depending on which instruments are being traded and whether the uncompensated margin rules (UMR) for swaps need to be considered. Expect to budget between 5-7% for initial margin requirements for equity futures and 2-4% for fixed income futures. Importantly, initial margin for futures contracts can be satisfied with physical securities, not just cash. Employing physical government bonds from an existing fixed income mandate is a popular strategy for improving cash efficiency. For the liquidity buffer used to support the daily market valuation of derivatives, we would suggest 10-15% for equity beta and 5-10% for fixed income beta. The size of the liquidity fund depends on many factors, including the availability of additional cash should market conditions become unfavorable. For example, if coming up with additional cash quickly is a challenge, it may be prudent to double these estimates to 40% notional capital and 20% fixed income. Finally, investors typically prefer that the collateral pool itself be included in the total overlay position so that the performance loss of the cash holding is minimized. This can be done as part of the portable alpha program or segmented into a cash capitalization program.

3. Assessment Changes

Overlay managers often have read-only access to the custody ratings of the hedge fund range so that adjustments to beta positions can be made in a timely manner. Investors who may have more timely records or valuation estimates can submit them to the overlay manager for faster implementation.

4. Built-in beta

Some clients have reviewed their hedge fund lineup and discovered a persistent beta that should be considered. An overlay manager can easily adjust the valuation of the applicable hedge funds so that the beta is not duplicated, thus minimizing the potential for beta leverage.

5. Exposure to synthetic hedge funds

For clients who want additional exposure to hedge funds but are concerned about underwriting delays or are having difficulty sourcing cash to fund those mandates, they may be able to get the same exposure more quickly, synthetically, through total return swaps, more a bit of a broker. fee. An alternative use case would be overlaying an existing physical beta position with exposure to synthetic hedge funds. While such an alternative involves the same components of alpha and beta, it reverses the convention of what traditionally are the physical and synthetic elements of portable alpha.

The bottom line

The rise of derivatives has allowed investors to think differently about the basics of alpha and beta in a portfolio context. By divorcing alpha from beta, investors can track the most efficient ways to achieve each. When beta can be effectively implemented through derivatives and alpha is provided by market-neutral hedge funds, the combination of the two can make for a wonderful marriage.

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