Portable Alpha – The Most-Talked-About Application of ‘Alpha’ is Becoming Reality
Todd M. Brussel, Alternative Investment Products
The Royal Bank of Scotland Group
Structured products and portable alpha are concepts that have been around for many years, but their synthesis has recently emerged as an upward-trending investment phenomenon, particularly among pension plans. When structured properly with due consideration given to risk tolerances, a structured portable alpha product employing a portfolio of hedge funds as the alpha source can be an attractive investment tool.
Structured products can be varied in complexity, but generally display three key characteristics: (1) self containment; (2) limited recourse; and (3) the bundling or unbundling of risks. Similarly, their application generally can be grouped into: (1) Risk-Reward Modification – leverage, principal protection or pooled versus single-asset risk; (2) Regulatory Structuring – tax or accounting; or (3) Investment Compliance – with investment mandates or legal restrictions.
Portable alpha’s thesis is to apply (or port) returns from alpha-generating strategies (those for which an active manager has a higher probability of producing investment returns in excess of a benchmark, such as hedge funds) to beta strategies (typically, liquid benchmarks). Implicit in the thesis is that beta strategies such as long-only large-cap stocks are highly efficient and, therefore, there exists a lower probability that an active manager can consistently produce returns (net of fees) in excess of his/her benchmark. Therefore, it can be more efficient to access the beta strategy in derivative format.
The benefits of synthesising structured products and portable alpha into structured portable alpha are illustrated in the following example. Suppose you had $100 million to invest and were targeting returns of at least equal to the S&P 500. The iShares S&P 500 Index (an exchange-traded S&P 500 tracker fund) has underperformed the S&P 500 itself at an annualised rate of -0.12% pa over the past three years according to Morningstar. An alternate means of accessing the S&P 500 would be to invest in a simple repackaging, in which a special purpose vehicle (SPV) holds (1) a Aaa/AAA-rated bullet-maturity collateralised debt obligation (CDO)-paying LIBOR + 0.3% pa; and (2) an S&P 500 swap costing LIBOR + 0.05% pa. The SPV investment is self contained and limited in recourse while bundling the CDO and S&P 500 risk. As a result, with Aaa/AAA certainty, you will receive the S&P 500 plus 0.25% pa (the spread between the CDO security and the cost of the S&P 500 swap) instead of the S&P 500 less 0.12% pa.
Applying the same concept to a portfolio of hedge funds can yield even better results. A well-diversified fund of hedge funds (FOF) typically targets returns of LIBOR + 3-6% (with 3-8% annualised volatility) over a market cycle. To achieve Aaa/AAA certainty, one could invest in a rated collateralised fund obligation (CFO)-yielding LIBOR + 0.5-0.6%, which would increase the outperformance in the illustrative repackaging to at least 0.45% above the S&P 500. One could also enter into a principal protected hedge fund structure where targeted FOF returns are reduced from LIBOR + 3% to LIBOR + 1.75% (assuming principal protection costs roughly 1.25%), in which case, the outperformance in the repackaging would be 1.7% above the S&P 500 (although the ‘certainty’ level might be reduced to an AA-level due to the rating of a typical protection counterparty or the spread reduced by 0.2-0.4% in order to hedge the risk of a particular protection counterparty for a given tenor).
The same technique can be applied to a variety of benchmarks such as the Nikkei, FTSE or even the Lehman Aggregate Bond Index. When mating any benchmark to an alpha source, though, it is always prudent to evaluate the correlation of the alpha and beta sources (FOF typically display low, sometimes negative, correlation to these benchmarks) as well as to back-test the structured portable alpha product. For example, if the benchmark has displayed high downside volatility, it may be prudent to consider employing options or puts in order to limit the downside of the benchmark.
In sum, a synthesised structured portable alpha product employing FOF can transform liquid, long-only investment exposure from one with a high probability of negative tracking error to one with a significant probability (to AA or AAA certainty) of meaningful outperformance. As with any structured product, though, investors should consult its legal, tax and other regulatory advisors or experts before making an investment.