New Putnam funds separate alpha and beta (nearly)

Retail Investing 06 Oct 2008

We’ve been waiting for the markets to cool down so we can get back to our primary focus here at, the ongoing evolution of the asset management industry.  But with breaking stories overwhelming the new cycle nearly every day now, that time never seems to arrive.  Still, today we take a much needed break from the all-too-familiar apocalypse countdown and examine an intriguing new fund that may be the poster child for what emerges from the impending financial ice age.

Putnam Investments is launching what it calls the “Absolute Return 100, 300, 500, 700 &1000” funds.  While the lower expected volatility of the “100” and “300” versions simply invest in sleepier asset classes that have a relatively low equity market correlation (namely fixed income securities), the rest of the funds share a unique attribute: they are constructed out of two distinct portfolios – an “alpha strategy” and a “beta strategy”.

According to the funds’ prospectus:

“The beta strategy of allocating assets among many asset classes generally depends upon the direction of the relevant markets for success, while the overlay strategies that comprise the alpha strategy are generally designed not to depend upon market direction for success. The beta and alpha strategies are intended to be uncorrelated and to operate largely independently, thus improving a fund’s chances of earning a positive total return regardless of market conditions. Both the beta and alpha strategies are dynamic, permitting us to take advantage of opportunities that arise from different economic conditions.”

This is a quintessentially alpha-centric way to manage money – in two distinct but complementary ways.  Unfortunately, Putnam seems to fall into the trap set by the hedge fund industry – promising “absolute” returns.

“Each fund is designed for investors seeking positive total return in excess of inflation over reasonable periods of time regardless of varying market conditions.”

Combining alpha and beta cannot, by its very definition, yield “positive total returns” – especially “regardless of varying market conditions”.  The beta portion of the fund is guaranteed to pull the fund down when markets are down, right?

Well, not quite according to the prospectus.  The beta strategy will actually invest in “less traditional asset classes to, in part, protect a fund’s portfolio from downturns in the equity and fixed income markets.”

Beta?  You be the judge.  In any event, like a prototypical portable alpha strategy, the funds will lever-up  beta to free up capital for the alpha strategy.  Beta leverage ranges from 150% of capital for the “500” fund  to 300% of capital for the “1000” fund and the prospectus says that the alpha strategies may also come with their own leverage.

As hedge fund investors are now all too aware, alpha strategies may be uncorrelated under normal circumstances, but simply reflect the markets in periods of turmoil.  Thus, warns Putnam:

“…while we intend the [alpha] overlay strategies to be relatively uncorrelated with one another and with the performance of most asset classes to which the funds are exposed through the beta strategy, it is possible that the performance of various asset classes and overlay strategies may be correlated under certain market conditions, which may negatively affect a fund’s performance…”

Each fund is designed for investors seeking positive total return in excess of inflation over reasonable periods of time regardless of varying market conditions.

“The beta strategy consists of a globally diversified asset allocation strategy. It seeks to balance risk and to provide positive total return by investing, without limit, in many different asset classes, including U.S. and international equity securities, U.S. and international fixed-income securities, currencies, commodities, real estate investment trusts, and inflation-protected securities.”

Unfortunately, the advisory fees paid by the fund are contingent on assets managed, not on whether those assets are part of the alpha or the beta strategies.  While you’d expect the alpha strategies should cost more to manage, Putnam Management, the fund manager will pay its affiliate Putnam Investments Limited a sub-advisory fee of 0.35% per annum.  (There is no word in the prospectus about what Putnam Management will actually charge the fund itself.)

So the bottom line is that this product is a step in the right direction – even if doesn’t exploit all the potential of alpha/beta separation.  Time will tell if this bifurcated approach can turn things around at the venerable firm.

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