Just as the media started to shovel dirt into portable alpha’s grave, Institutional Investor ran a very well-balanced piece this month about the trials and tribulation of the once-mighty strategy (written by Imogen Rose-Smith). Anyone who faces questions from investors, pensioners, or investment board members about portable alpha strategies needs to read all 4200 words of it.
It begins with the usual colorful and dichotomous language you’d expect to see in relation to such a controversial topic, such as “the Rosetta Stone of investing,” and “the toxic waste of portfolio strategies.”
Rose-Smith writes that:
“Portable alpha conferences sprang up like umbrella salesmen during a downpour in Times Square. Articles on portable alpha became a deluge of their own. As many as 50 a month were being published by 2006, estimated John Coates, head of Morgan Stanley & Co.’s portable alpha program, and Mark Baumgartner, the bank’s portable alpha portfolio manager, in an article of their own.”
While Morgan Stanley (and AllAboutAlpha.com, the small research blog it sponsored into existence) was busy trying to keep people dry in Times Square, the wind began to howl, making even the best umbrellas ineffective.
Requisite hyperbole dispensed, Rose-Smith then begins to ask the critical question:
“Is portable alpha truly to blame? Or is it possible that a perfectly valid, rather ingenious portfolio management approach was misunderstood and hence misused? Should a Committee to Save Portable Alpha be formed, if only to preserve a legitimate strategy for a more circumscribed function?”
In other words, did the Force 12 gale in Times Square prove that umbrellas are a bad idea?
Clearly not. As Rose-Smith writes, hedge fund managers were tasked “with one simply injunction: ‘Beat the market, any way you know how’.” Although the alpha portions of portable alpha strategies took a bath in 2008 (down 20% on average), they did in fact beat the market. That’s why we proclaimed 2008 to be one of the best years ever for hedge funds.
The article also touches on one operational issue that seems to have caught investors by surprise – the possibility that the derivatives-based beta exposure would tank so badly (in concert with the equity markets) and that more cash collateral would have to be put up – necessitating the sale of a portion of the (illiquid) alpha portfolio.
This was a very real problem for some. But the fact that alpha portfolios (made up of quant strategies and/or funds of funds) contained a lot of beta doesn’t negate the value of portable alpha as a portfolio construction approach.
Rose-Smith cites incidences of hedge fund fraud as one reason institutional investors have turned their back on portable alpha. But we’d suggest that incidence of hedge fund fraud should make investors second guess their due diligence procedures, or perhaps even their decision to invest in hedge funds, but not their decision to separate alpha and beta.
As she writes:
“Often the intellectual underpinnings of any given strategy are perfectly sound but poorly understood, and, as a result, the strategy is misapplied and mismanaged. That is precisely what happened with portable alpha in many cases.”
She reluctantly concludes that “it may not be correct to label portable alpha snake oil…” but also quotes AllAboutAlpha.com contributor Keith Black, CAIA who said “Clearly, the actual risk was higher than the anticipated risk.”
Rose-Smith ends with this fair and balanced conclusion – one that reaffirms our belief that the failure of an umbrella in Times Square gale should stop you from trying to stay dry.
“In any case, separating alpha and beta return streams still has validity. Mark Carhart, who retired as head of quantitative strategies at Goldman Sachs Asset Management last year, thinks managers should separate investment returns into beta and “true alpha” and price them accordingly. “All managers have their embedded beta,” he says. But investors should not pay high fees for beta, Carhart asserts.
Portable alpha might be in disrepute among many public funds, but what the strategy represented from the outset — a loosening of portfolio manager restrictions, the use of leverage to enhance returns and reliance on quantitative investing techniques — is not about to slink away from the scene. Paradoxically, portable alpha’s setbacks might encourage public funds that invested in hedge funds indirectly to now invest in them directly. And after a hiatus they will surely explore other leveraged, quantitative approaches to investing. But they had better read the instructions carefully first.”
In related news, it seems that there are still a lot of major investors that like umbrellas…
- Arizona Public Safety Personnel Retirement System allocates $300 million to portable alpha (Mar. 2010)
- Iowa Public Employees’ Retirement System allocates $200 million to portable alpha (Dec. 2009)
- South Carolina CIO says “the only thing that really went wrong … was assuming that your alpha engines were more stable and uncorrelated than they were…” (Feb, 2010)
Editor’s Note: Check out the number of Google News articles on “Portable Alpha” over time.
Despite continued interest, it looks like the “deluge” of hype raining down on portable alpha did indeed peak in 2006…