Portable Alpha: Is a Hedge Fund Index-based Alpha Overlay the Most Appropriate Solution?
Werner Goricki, Dirk Soehnholz, Marcus Storr, Vincent Weber
Feri Institutional Advisors, Bad Homburg/Germany
“Portable alpha” is a widely discussed concept in Europe as well as in Asia. However, successful implementation has been rare. We will discuss three basic concepts that can be applied to institutional portfolios or investment funds. Hedge funds are identified as the most attractive source of alpha. An alpha overlay (swap) is described as the most efficient way to import alpha into existing portfolios and investment funds. Such a swap can add significant additional return without adding a proportional amount of risk to the portfolio. Single hedge funds will be compared with funds of hedge funds and hedge fund indices regarding their suitability for alpha swaps. Investible hedge fund indices offer transparency and other advantages and thus are further analysed. Finally, regulatory and technical implementation issues are discussed based on a successful alpha overlay implementation by Feri Institutional Advisors for a mutual fund with a European distribution passport (UCITS).
The term “portable alpha” is very popular these days. At the first European Portable Alpha Conference organised by Terrapinn in December 2005, all kinds of concepts were presented and many buzzwords were used in connection with portable alpha: absolute return, liability driven investments, asset liability management, derivatives, defined contribution, retail, risk budget, tracking error, excess returns, private equity, real estate, mezzanine, manager selection, multiple alpha, negative Alpha, benchmarks, emerging markets, diversification, outperformance, correlation, fees …
Alpha and Beta Defined
To understand the concept, firstly “alpha” has to be defined. Alpha is a return that is unsystematic and uncorrelated to a general market direction and risk, whereas beta is a systematic and market related return. The most important question is, what is “general market”? Do we only talk about overall stock and bond markets or are there “alternative betas” like credit spreads etc. This issue will be addressed further below.
Investors usually want to have both alpha and beta in their portfolios. According to widespread opinion, beta can best be implemented using index products, with active portfolio managers providing the alpha. The “ideal” portfolio therefore would consist of beta index products and alpha managers.
Three Different Approaches to Port Alpha
The portable alpha concept tries to enable investors to access more and better alpha sources. There are basically three ways to achieve additional alpha.
Solution 1: Portable alpha can be called “alpha (directly) replaces beta (alpha for beta)”
The approach is to replace a portion of the existing portfolio – usually by selling beta exposure – with a pure alpha investment. The major disadvantage of this approach is that the asset allocation of the portfolio has to be changed, since the alpha investment replaces the beta investment. As such, alpha is not earned on top of but instead of a systematic risk premium. Additionally, many investors or portfolios are not allowed or willing to invest in pure alpha strategies directly because of there high “tracking error” or because they are defined as hedge funds.
Solution 2: Portable alpha may be called “hedging out (unwanted) beta (beta transfer)”
In this case managers/funds will be selected based on their ability to generate alpha, without considering the nature of their systematic risk exposure. To avoid potentially unwanted beta risk, it will be swapped out of the portfolio and replaced by the “desired beta” (or alternatively risk free returns). In theory, a diversified hedge fund of funds could constitute the majority of the portfolio. In practice, the portfolio would consist of mostly high tracking error long-only managers. A major obstacle to this approach is that most investors would have to replace a substantial portion of their existing allocations, causing regulatory problems and/or significant transition costs.
To accommodate the desired investment amounts, it often also means using a large number of managers with the ability to produce Alpha. Additionally, the implementation of this approach requires significant use of derivatives to hedge out the undesired beta and buy the desired beta.
Solution 3: Portable alpha as an “alpha overlay”
In this case the existing portfolio with all beta exposure remains unchanged, and the performance of pure alpha managers is imported via a total return swap. As the short-term interest rate is swapped for the performance of an alpha manager, the investor receives “pure” alpha. By applying this technique, the existing portfolio does not change and only one derivative could be used to provide access to the alpha. This seems to be the most efficient and promising approach. This approach is not limited to portfolios of institutional investors but investment funds can also be structured in this way.
Chart 1: Overview of “Portable Alpha” Approaches Click on the image for enlarged preview
Source: Feri Institutional Advisors
Hedge Funds as the Most Efficient Source of Alpha
Most investors want to generate or buy alpha by using active long-only portfolio techniques and managers. But these may only use a limited spectrum of alpha generating instruments, dependant on the opportunity in their respective market segments and investment structures.
Active portfolio management can be most successful in an environment without artificial restrictions. Typical alpha-limiting burdens are restrictions regarding asset class, geographic allocation, short selling, use of derivatives and leverage. Hedge funds, different from traditional funds, typically operate in structures with no or very little external limitation to the implementation of a manager’s strategy, and as such they provide a well-suited structure for alpha generation.
In recent years, a vast amount of studies regarding the merits of hedge funds have been produced. For our purposes, two widely accepted results should be highlighted. First, hedge funds do not generate all of their returns through pure alpha strategies. However, systematic risk can be controlled and reduced (or even neutralised) by a portfolio diversification. Second, along with a lot of often-valid criticism, there is solid evidence that well managed hedge funds do generate alpha over time.
To illustrate the complexity of the analysis to identify pure or true alpha, here are some facts: There are thousands of potential beta factors. Feri identified some two hundred factors that are expected to potentially significantly influence investment fund returns. The Feri database contains almost 20,000 so-called hedge fund time series. About 8,500 of them can be considered separate single hedge funds time series. Out of those, only 1% is currently included in Feri advised hedge fund portfolios. Most of the others have been found to have significant and stable beta exposure. Whereas a beta portfolio which is actively managed and changes market exposures over time may be considered as attractive tactical asset allocation (many global macro funds are essentially beta “players”), usually investors should not pay hedge fund fees for stable beta exposures.
Having accepted that portfolios of hedge funds can provide an efficient source of alpha but do not usually consist of pure alpha, the question about residual beta exposure of such portfolios remains. There are two approaches to such residual systematic exposure. First, residual systematic exposure can be identified and eliminated by the use of index derivatives. This is the approach taken in a recent study by William Fung and David Hsieh1, resulting in highly attractive performance contribution despite the loss of the residual beta return. Alternatively, the portfolio of hedge funds can be constructed in such a way that systematic exposure is neutralised in the long term by active diversification. This second approach has the advantage that any short term systematic exposure is considered as an active investment decision by the hedge fund managers, recognising that such “temporary beta” is an integral part of the alpha generation process.
Another very important feature of hedge funds is the fact that they are usually absolute return vehicles. This can be partly explained by the fact that hedge fund managers typically invest a significant part of their private wealth in their own funds. And these managers usually hate to lose their own money. Also, they often only receive significant fees if they generate absolute returns and not for beating markets whilst still losing money.
As a source of alpha such absolute return funds are more attractive than relative return or benchmark oriented funds, which also produce alpha, since the whole fund return can be used for a portable alpha concept. With relative return funds, the beta or relative return has to be eliminated from the fund first before the remaining alpha can be used for – respectively swapped into – the target portfolio.
Advantages of Investible Hedge Fund Indices Compared to Funds of Hedge Funds
In order to attract potential alpha from as many sources as possible, different hedge fund strategies should be incorporated. Also, usually different people should manage the different alpha generation strategies. This leads to a hedge fund of funds as ideal source of alpha. Direct hedge fund of funds investments may be considered as active alpha sources on both levels of the fund of funds and the single fund. Hedge fund index investments are rather “semi-passive”. But direct hedge fund of funds investments are often not eligible for – or only difficult to integrate into – investor portfolios or existing investment products. One reason for this might be the provisions against cascading fees. Whereas investible hedge fund indices also come with an additional fee level compared to single hedge funds, the “derivatives” reflecting hedge fund index performance are often are easier to buy in different legislations than funds of funds directly.
In addition, single hedge funds and funds of funds need to be IFRS consolidated if institutional investors want to acquire a significant stake of them, which is often assumed to be 20% in a single entity. Derivatives do not necessarily fall under these provisions. On the other hand, most hedge fund indices are either not investible – which means that they can not be easily tracked by a derivative issuer – or are unattractive in terms of real (compared to pro forma) returns and risk.
Since 2003 and mainly in Europe, a lively debate has been going on about hedge fund indices. This discussion was motivated by consultants’ desire to find reliable time series to benchmark hedge funds against, and by the search for valid and widely accepted measures for general hedge fund performance. Whereas many non-investible hedge fund indices may have all kinds of well analysed and publicised biases regarding fund selection, data backfilling, etc, investible hedge fund indices can comply with the CESR (Committee of European Securities Regulators) guidelines for financial indices in general. CESR even recommends allowing derivatives on commodity and real estate indices to be included in UCITS funds which can be freely distributed Europe wide to retail investors. Investible hedge fund indices may be generally recognised as eligible investments still in 2006 for these retail investment funds.
As of early 2006, broadly diversified investible hedge fund indices which may fulfil the CESR criteria are being calculated and published by CSFB, Hedge Fund Research (HFR), Standard & Poor’s, FTSE, Feri (ARIX index line) and Van Hedge. Dow Jones so far only publishes strategy specific indices.
ARIX, the first of these indices, started in early 2002. Today, evidence suggests that more than EUR 10 billion have been collected by the so-called investible hedge fund index products. After an early success mainly in 2004, net inflows in 2005 slowed down substantially.
Hedge fund indices are usually designed to be broadly diversified and to bear little risk. Also, they are usually more transparent in terms of strategy allocation and fund selection process than funds of hedge funds. But they have been criticised for not reflecting typical hedge fund returns. This is only partly true. Non-investible indices cannot be tracked since they contain too many funds including many funds that do not accept additional money. So the relevant universe for investors consists only of investible indices. They differ in the number of funds, the weighting of funds and strategies and other factors. Most indices also differ in the number and definition of sub-indices; some index providers do not even provide composite indices. To generate alpha, the more representative sub-indices are available, the better the theoretical ability to generate alpha through hedge fund strategy allocation.
But the only significant performance–relevant difference between them seems to be their basic fund selection universe. Whereas ARIX, the CSFB Tremont and the Van Hedge investible index contain standard offshore hedge funds, the other well-known investible hedge fund indices (eg HFR, S&P, MSCI, FTSE, Dow Jones) are based on so-called managed accounts. Unfortunately, managed accounts based indices appear to have a disadvantage in terms of returns when compared to offshore fund based indices. This can be explained by the selection bias of managed accounts platforms, since not all hedge funds are willing to offer such accounts, especially if they are asked to provide more frequent liquidity compared to their offshore investors. In addition, the lower return is partly due to the significant additional cost of managed accounts which include statistically significant negative tracking errors of the managed accounts compared to the respective offshore funds (see “Hedge Funds: Too late again?” by Dirk Söhnholz in IPE, Nov 2005).
A performance comparison of these investible hedge fund indices is shown in Table 1.
Table 1: Hedge Fund Index Comparison Click on the image for enlarged preview
Source: Feri Institutional Advisors GmbH and other index providers
As of 31 December 2005
ARIX, the offshore funds based index with the longest real performance history, tracks the widely used HFR Fund of Funds Composite Index very well (see Chart 2).
Chart 2: ARIX Composite versus HFRI Fund of Funds Composite Index, S&P Hedge Fund Index Click on the image for enlarged preview Source: Feri Institutional Advisors
Since inception in January 2002, the ARIX index has generated annual returns between 1.5% and 11.5% with a standard deviation of monthly returns under 3%, limited drawdowns of less then 2%, and very low or no correlation with general market indices: Precisely what one should expect from an absolute return benchmark.
Illustrative Example of a Hedge Fund Based Alpha Overlay
The example below shows that an alpha swap can generate significant additional return with very little additional risk. To give an idea of the effects of a hedge fund based portable alpha solution, we create a simple example, based on a standard German institutional portfolio allocation containing 90% bonds and 10% equities (Chart 3).
Chart 3: Return and volatility of a traditional portfolio containing 90% bonds (Lehman Aggregate Bond Index)and 10% stocks (MSCI World Index) Click on the image for enlarged preview Source: Feri Institutional Advisors
The alpha overlay solution is then achieved by adding a total return swap on the ARIX index with a notional amount of 10% of the total portfolio value, while leaving the original asset allocation in bonds and equities unchanged.
As can be seen in Chart 4, this small allocation of only 10% to additional alpha already significantly improved the return of the traditional portfolio by an average of 30 basis points per year over this rather difficult hedge fund period from 2002 to 2005. Also, in comparison to a 10% direct investment into ARIX (Solution 1), the alpha swap solution compares favourably.
Chart 4: Change of Returns by Adding Alpha to a Traditional Portfolio Click on the image for enlarged preview Source: Feri Institutional Advisors
The only year in which the alpha overlay solution leads to a slight decrease in absolute and risk-adjusted return is in 2002, a year in which the standard portfolio had its best result, due to very strong bond markets (Chart 5).
Chart 5: Comparing Sharpe Ratios for Different Portfolios (3% Risk Free Rate Assumed) Click on the image for enlarged preview Source: Feri Institutional Advisors
This can be seen as further evidence of the smoothing properties of hedge fund alpha, resulting from its non-correlation properties. Overall, the alpha overlay (swap) approach (Solution 3) has added a significant return (Chart 4) while only slightly increasing the volatility of the portfolio from 3.48% to 3.56% over the analysed period, while the direct ARIX investment (“alpha for beta” Solution 1) has in particular reduced the portfolio’s volatility. Interestingly, as shown in the table below (Table 2), in terms of maximum Sharpe ratios and minimum maximum drawdowns, it is the pure hedge fund portfolio, ie 100% ARIX, that shows the most attractive attribute compared to the other three solutions described above.
Table 2: Arix Swap and Direct Allocation Compared to a Standard Portfolio
90% Bonds, 10% Stocks
80% Bonds, 10% Stocks, 10% ARIX
90% Bonds, 10% Stocks, 10% Face Value ARIX Swap
source: Feri Institutional Advisors
Implementation in UCITS and institutional investor portfolios (eg for liability-driven investments)
Meanwhile, the first UCITS have been approved that reflect the above-mentioned approach. UCITS are regulated mutual funds that are allowed to be publicly distributed throughout Europe. But UCITS are not only relevant for retail investors. Most institutions and funds of funds can readily access these funds and incorporate them in their portfolios and are usually not much restricted by regulations on the use of these funds. Buying derivatives on hedge fund indices has often advantages over direct investments in hedge funds or funds of hedged funds, which vary by legislation and customer group. In any case, investible indices usually provide high levels of diversification and transparency, especially regarding the strategy allocation and hedge fund selection process which is considered favourably by most internal decision makers, external boards and regulators.
Also, the alpha swap concept is very attractive in the context of liability-driven investment strategies. These are designed on the basis of reflecting and assuring the short, medium and long-term liabilities of institutions. Therefore they often consist of significant allocations to bonds and especially long-dated bonds for the long-term liabilities. The alpha overlay can easily be applied to such portfolios in order to increase the level of expected returns to the prospective investors. In such a respect an alpha overlay is not a competition but rather an addition to tactical asset allocation or other overlays. But one could also argue that tactical asset allocation and currency overlays would better be managed by experienced, basically unconstrained and independent (hedge) fund managers instead of long-only managers, especially if they are part of an investment bank.
The Mechanics of an Alpha Swap Implementation
The following chart shows a detailed example and visualises the mechanics of an “alpha swap” using ARIX performance swapped against a risk-free floating rate.
Chart 6: Alpha Swap: ARIX vs Cash Click on the image for enlarged preview Source: Feri Institutional Advisors
In the implementation process issues such as swap liquidity, currency hedging, reporting, collateral, index tracking error treatment, fees etc have to be solved. Few banks have significant experience in this area. Also, several administrators and custodians which where approached to quote fees on swap administration services where not able to make an offer at all. So business partner selection is very important.
Portable alpha is a popular and widely discussed concept. Three basic portable alpha concepts that can be applied to portfolios or funds have been discussed. Hedge funds are identified as the most attractive source of alpha, and the concept of an “alpha overlay” using investible hedge fund indices was explained in detail. It was shown that such an alpha overlay could add significant additional returns to almost any portfolio without adding a proportional amount of risk. Hence such alpha overlay should be considered by investors as a very attractive tool to enhance overall portfolio returns. However, successful – especially hedge fund based – implementation has been realised in only very few instances. Subsequently a case study mentioned some of the major implementation hurdles and how they can be overcome.
Note:Feri Institutional Advisors (FIA) is an investment advisory and consulting company and is a 100%-owned subsidiary of the Feri Finance Group, which is based in Germany, 15km north of Frankfurt. FIA advises institutional clients, mainly private banks but also insurance companies, pension funds and Independent Financial Advisors. Assets under advisory contracts for FIA and Feri Wealth Management currently amount to about EUR6.5 billion; with hedge fund of funds AuM of approximately US$500 million. The Feri Finance Group has approximately 200 employees of which 45 people are working within Feri Institutional Advisors. The hedge funds department consists of 11 people (7 investment professionals). Feri has been selecting hedge funds since the mid-90s and the dedicated hedge funds investment team was set up in 1999. For more information, please call+49 6172 916 0.
1William Fung and David A. Hsieh. “Extracting Portable Alpha from Equity Long/Short Hedge Funds”. Journal of Investment Management, Vol. 2, No. 4, (2004).