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).
“These investment strategies commonly employ derivatives and abundant leverage to generate ‘excess’ returns. In contrast, in my early days at PIMCO in the 1980s, we utilized the inherent ready-made leverage of financial futures and the to be announced (TBA) mortgage market in an unleveraged manner to produce alpha. The concept was simple and elegantâ€”arbitrage the low implied cost of financing imbedded within the futures contract and the higher prevailing high-quality market rates of interest for short-term bonds, a strategy we referred to as ‘BondsPLUS.’ At that time, financial futures were the only derivatives available, and high quality, unleveraged investment standards were rigid…”
“The transformation of alpha engines from high-quality financing arbitrage to leveraged beta strategies, called alpha, stands in sharp contrast to the prevalent conservative attitude of the 1980s. The structured products market is a good example of statistical engineering, whereby leverage is used as a tool to create products with return promises too good to believe. Structured corporate bond products provide leveraged exposure to the corporate market and benefit from book value accounting.”
He goes on to explain how few investors are familiar enough with the statistical dimensions of many new and complex investment products and how “compressed spreads and low volatility” actually imply higher risk, not lower risk.
In addition, he explains how the current economic environment in the US (the “war on terror”, the Fed, and household debt) coupled with “financial schemes that incorporate highly leveraged strategies” are in his words “very binding on public policy.”
In conclusion, he expresses his frustration that his invention has been used as a cover for more questionable pursuits:
“Ironically, what began in the early 1980s as a simple finance arbitrage PIMCO portable alpha strategy has evolved in some cases to highly levered, unregulated portable alpha hedge fund strategies. Both are referred to as the alpha source in a portable alpha context, but they are vastly different in terms of the potential downside risk.”
But rather than giving up on innovations such portable alpha altogether, Dialynas urges both investors and policymakers to be more realistic about return expectations:
“Understanding the embedded risks, assumptions, and changing risk character of the various types of portable alpha strategies, as embedded options are attached and alpha morphs into beta, is the main point of this book. To truly accomplish this for portable alpha approaches and other investment schemes more broadly, politicians, policy makers, and investors alike must recognize that double-digit investment returns in a low single-digit interest rate world are inconsistent, likely of very high risk, unsustainable, destabilizing, and subject to severe loss potential.”
(Excerpted with permission of the publisher John Wiley & Sons, Inc. from Portable Alpha Theory and Practice: What Investors Really Need to Know. Copyright (c) 2008 by Pacific Investment Management Company, LLC. This book is available at all bookstores, online booksellers and from the Wiley web site at www.wiley.com, or call 1-800-225-5945.)