Alpha being airlifted out of dying portable alpha strategies

airliftIt seems that after losing their shirts in equity beta, a surfeit of pension funds are now swearing off portable alpha strategies.  Late last year, we discussed how the Pennsylvania State Employees Retirement System (SERS) had taken an equity bath during 2008.  And Pensions & Investments reports this week on two other major public plans – in Massachusetts and Colorado – that have opted to call it day when it comes to portable alpha.  Even the mythical California Public Employees Retirement System (CalPERS) has recently decided to wrap up its portable alpha program (Ed: Great reporting in these P&I pieces btw.  Well worth a read.)

This website was launched just as the notion of alpha/beta separation was beginning  to take hold.  Over the past 3 years, we have advocated for the delineation of alpha and beta, both conceptually (in a portfolio and fee analysis context) and literally (as in portable alpha programs).  By virtue of their focus on alpha-centric returns, alternative investment strategies such as hedge funds were a natural source for the alpha-centric portion of these strategies.

Unfortunately, the term “portable alpha” quickly became synonymous with hedge funds themselves.  Generally, when someone asked whether a fund has adopted a portable alpha strategy, they really meant to ask if the fund had invested in hedge funds.

Portable alpha strategies, however, were simply a flexible construct that combined hedge funds and market (beta) in a form that loosely approximated traditional active management.

Proponents of hedge funds argued that investors should forsake beta entirely and invest solely in alpha-centric hedge funds.  Opponents charged that hedge funds were a mugs game and that beta was proven commodity.

So it may come as no surprise to critics of hedge funds that portable alpha has lost its luster.  But what may come as a surprise to them is the fact that it was traditional market beta, not the hedge funds, that led to its apparent undoing.

“Portable Alpha” is dead – long live portable alpha!

As P&I reports, Massachusetts Public Reserves Investment Management Board (Mass PRIM) and the Fire and Police Pension Association of Colorado both lost their shirts on the beta portion of their portable alpha strategies.  In fact, the newspaper reports that the Colorado plan is actually looking to double its current allocation to absolute return strategies.

While dumping its portable alpha approach, Mass PRIM will still be maintaining its absolute return allocation at current levels – splitting it between its existing hedge fund bucket and its global equity bucket.  Similarly, Pennsylvania SERS has “dismantled” its portable alpha program, but actually created a whole new investment category for its existing absolute return allocation.

The Real Culprit: Beta

These moves highlight the fact that portable alpha can be looked at two ways: as an alpha overlay on a beta (traditional) allocation or as a beta overlay on an alpha (absolute return) allocation.   To its credit, CalPERS seems to view things the second way, as a beta overlay on its absolute return allocation.  Reports P&I:

“CalPERS doesn’t have a portable-alpha program, at least officially. But sources said the beta overlay run on top of the Risk Managed Absolute Return Strategies portfolio produced the dismal results similar to portable-alpha programs employed by other institutional investors.”

It seems that the CalPERS beta overlay was implemented to prevent the overall pension fund returns from diverging too much from the benchmark index.

Unfortunately, it succeeded.  Despite positive returns for the fund’s alternative investments bucket, the beta overlay simply ensured that California’s public employees were subsequently impoverished just like the rest of us.

According to P&I, CalPERS added its beta overlay in response to “performance drag” between 2003 and 2007 as the market shot upwards.  By May 2008, after watching equity beta make everyone rich, they finally gave in and hitched their wagon to the markets by shoring up its beta exposure.  Not the best timing for sure.

Here’s how the plan’s general consultant, Wilshire Associates described the situation to the plan’s CIO Joseph Dear in an August 2009 report for the board:

“Staff began adding a beta (market exposure) overlay to the RM ARS [Risk Managed Absolute Return Strategies] program a few years ago. Despite RM ARS relatively strong performance versus its benchmark, RM ARS underperformed the broad stock market from 2003 to 2007. As a result, RM ARS was a drag on the returns of the total of Global Equities versus a market benchmark…

…If such an overlay is not desired, then the Investment Committee may wish to exclude RM ARS from the performance of the Global Equity composite…”

The report included the following table showing just how badly the alpha-centric program was beaten down by the beta overlay (click to enlarge):


A Market Call?

So does this suggest that portable alpha may have been a market timing strategy all along?   Not necessarily.  But the separation of alpha and beta decision-making does provide investors with new tools to shoot themselves in the foot.  And that seems to have happened in California, Massachusetts, Colorado, Pennsylvania and countless other public pension funds.

In the end, the absolute return inspired proponents of portable alpha may have had the last laugh.  While portable alpha seems to be on its death bed, alpha-centric investing seems to be alive and well.

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  1. John Wartman
    October 1, 2009 at 10:58 am

    The beta component of a portable alpha strategy should have been recognized as leverage. The alpha component, usually a Fund of Hedge Funds, did better than the beta component but failed to adequately protect the downside, losing 15 to 20%. The idea of combining the strategies in portable alpha was a creation of misdirected “rocket scientists” whose mandate was to sell product. Any risk system or stress testing would have shown the compound loss potential due to the leverage.

  2. Rene Levesque
    October 4, 2009 at 6:43 am

    I totally agree with the comment posted by Mr. Wartman.

    The “misdirected rocket scientist” easily convinced the non-sophisticated corporate pension plan committee that is was a good idea, as a principle.

    This “misdirected rocket scientist”, offering not only asset allocation services, has encroached on the manager selection business, assuming that they were also equipped with the tools to identify alpha-generation engines, and obviously proposing their services to that committee (why not, it’s good business).

    They clearly failed at this, and the resulting portfolio effect can better be described as “portable leverage”, i.e. leveraged beta that severely hit the plan assets in 2008.

    But guess what? These “misdirected rocket scientists” now have a new fee generating business for these now more-than-ever-desperate pension committees, its called “portfolio immunization”. Unfortunately, the committee has no choice but accept another invoice by these “misdirected rocket scientists” .

  3. Eric Hirschberg
    January 11, 2010 at 10:39 pm

    Here is the issue with portable alpha as I see it. If one mis-specifies the risk benchmark, then a beta (no matter how plain or exotic) becomes an alpha. In a liquidity meltdown, if betas then correlate, the investor is left with a leveraged beta bet. This bet’s conditional return distribution leaves the investor with a simple leveraged beta. This creates an outcome that is far worse than the beta one started out diversifying in the first place. Everything can be ported, just make sure what you are porting is really alpha.

  4. Rene Levesque
    February 1, 2010 at 5:38 pm

    There is nothing wrong with the proper harnessing of beta (tactically) to derive absolute returns. This can be accomplished through (1) the dynamic sizing of individual positions, and (2) the dynamic calibration of the net portfolio exposure. However, it must be undertaken within a disciplined trading framework. Absolute returns have very little (or absolutely nothing) to do with investing; it is obtained through disciplined trading. That is where it comes from, i.e. the proprietary trading desks.

    Here is another recent reading on the issue:

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