Monday, August 29, 2005


Absolute Return Managers Use Multiple Alphas

Issue Date: August 22, 2005
Publication: Pensions and Investments
Absolute-return managers play the field to find alpha
Quant firms make more tactical bets, avoid relying on only one strategy
By Joel Chernoff
August 22, 2005

One source of alpha no longer is good enough: Managers offering absolute-return strategies that amass gains from a host of different alphas are all the rage.

At the top of the heap is Bridgewater Associates Inc., Westport, Conn., whose $17.2 billion in assets run in its “pure alpha” strategy has more than tripled since January 2004. The strategy seeks added value from 77 sources of alpha, derived from seven broad categories.

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“Bridgewater is minting money out of these strategies. They’re doing phenomenally well,” said Peter Gerlings, senior partner at New England Pension Consultants, Boston.

A few other firms, chiefly quantitatively driven managers, are also benefiting from the trend, including: Barclays Global Investors; First Quadrant LP; Goldman Sachs Asset Management; Grantham, Mayo, Van Otterloo & Co. LLC; Mellon Capital Management Corp.; Pacific Investment Management Co.; and UBS Global Asset Management.

“There’s more demand than what the industry is able to meet,” said Ken Kroner, managing director and head of global markets research at San Francisco-based BGI. BGI closed a quantitative global macro fund, launched in 2001, at nearly $4 billion; a traditional multistrategy fund started this spring has $200 million in assets and is experiencing strong demand.

Variety of sources

Having a variety of alpha sources keeps these managers from relying on one strategy that may be in or out of favor during a particular time period. They can typically make tactical bets, moving assets to where the most promising sources of alpha are, whether they are asset classes, countries or currencies.

Plus, having multiple sources of alpha drives up the information ratio, a measure of the portfolio’s efficiency on a risk-adjusted-basis. The information ratio is “very important” when talking about these strategies, “because you can’t really talk about returns,” said Greg Nordquist, senior consultant at Russell Investment Group, Tacoma, Wash. All of these strategies are examined in light of how much risk they’re taking, he said.

Using a variety of alpha sources improves consistency of returns, eliminating wild performance swings. That’s a big selling point after declining stock markets and falling interest rates threw most pension funds into deficit.

“We do actually prefer multiple sources of alpha, mainly because of the diversification reason,” Mr. Gerlings said.

“Most of our client base have moved toward an absolute-return environment, where they are more focused on their liabilities. Relative returns don’t fit their needs as in the past,” said Brian Singer, chief investment officer at UBS, Chicago.

Officials at the $780 million Edna McDonnell Clark Foundation, New York, recognized early on that they were going to find it more difficult to meet the foundation’s target return of 5.5% after inflation.

“We began to talk to UBS and others, (telling them to) forget about traditional benchmarks, think about our goals — 5.5% real over an extended period — and make sure that we are using, to the fullest extent possible, the resources of UBS’ talent bank,” said John M. Emery, chairman of the investment committee.

From 2002 through 2004, Clark Foundation officials converted three of the fund’s global balanced mandates into absolute-return strategies, totaling 55% of foundation assets. Grantham, Mayo, Boston, was charged with investing in any of its in-house strategies, though hedge funds were capped at 20% of its total mandate. Wellington Capital Co. LLP, Boston, was given a similar brief. UBS was the last piece of the puzzle, delayed until early 2004, when the firm’s “dynamic alpha” strategy had been fully tweaked, Mr. Emery said.

Wellington and UBS each manages about $135 million for the foundation, while GMO has a slightly larger portfolio.

Roots in TAA

These multistrategy products stem from domestic tactical asset allocation strategies, 1980s-era strategies that make tactical bets on U.S. equities, bonds and cash. Global versions of these strategies became somewhat successful in the 1990s, but the booming stock market limited the appeal, because they frequently sell stocks as share prices rise.

But hedge fund-of-funds — essentially a different type of multiple alpha strategy — have “warmed (investors) up to the concept,” said Max Darnell, partner and chief investment officer at First Quadrant, Pasadena, Calif.

“The other thing that’s happened here is an increased appreciation for the importance of breadth (making multiple types of bets) in constructing portfolios. Strategies that target single market inefficiencies or a small number of market inefficiencies are simply doomed to underperform those strategies that have access to a wider array of market inefficiencies,” Mr. Darnell said.

These strategies have taken on an ever-more exotic bent. In the 1990s, First Quadrant added currency bets and, later, volatility arbitrage. The firm now manages about $10 billion in multistrategy products, more than half of which were won in the first half of 2005. Similarly, Mellon Capital, San Francisco, manages $9.7 billion in absolute-return strategies and recently launched Global Alpha II, an absolute-return strategy that actively manages exposures to global stock, bond and currency markets.

Another success story is Newport Beach, Calif.-based PIMCO’s All Asset Fund, for which asset allocation decisions are made by Research Affiliates LLC, Pasadena, Calif., and investments are made in underlying PIMCO funds that invest in both traditional asset classes and alternatives. The fund, launched July 1, 2002, has doubled its assets under management since December, hitting “north of $8 billion,” said Robert D. Arnott, chairman.

The latest trend is offering strategies that package bets on both market exposure and securities selection.

Clients are asking executives at Goldman Sachs Asset Management, New York, to “give me your best alpha sources plus your most diversified beta sources” and figure out how much to allocate to alpha and beta, said Mark Carhart, managing director and co-chief investment officer of GSAM’s quantitative strategies group.

“The strategy looks a lot different than a traditional asset allocation. There are a relatively small amounts of equities and a large amount of absolute-return strategies, and an atypical amount of exotic betas,” such as commodities or emerging market debt or equity, Mr. Carhart said.

William Mahoney, director, business development, at Bridgewater, said some clients are asking the firm to overlay its pure alpha strategy on top of its “all-weather” strategy, which makes market exposure bets only. Within the last two years, 15 clients have allocated a total of $5 billion to the combined strategies.

“That’s very attractive, because ‘all weather’ has a different beta exposure” than typical asset mixes, Russell’s Mr. Nordquist said.

UBS’ dynamic alpha more closely resembles a traditional global balanced portfolio, but also makes bets on both alpha and beta. “We take market risk when we feel that market risk is appropriately compensated, and we take active risk, or alpha, when we feel that that risk is adequately compensated within the portfolio,” UBS’ Mr. Singer said.

UBS runs $3.6 billion globally in the strategy, of which $2.2 billion is for institutional or high-net-worth clients. The Clark Foundation is the firm’s only U.S. institutional client, but it has also raised more than $800 million from a U.S. mutual fund version launched in late January.

Sunday, August 28, 2005


Institutions Expand Portable Alpha Use

Issue Date: July 11, 2005
Publication: Pensions and Investments
Lower returns put portable alpha in better light
By Joel Chernoff
July 11, 2005

Institutional investors are expanding their portable alpha programs in hopes of beefing up anemic stock and bond returns.

While the virtues of portable alpha have been preached for years, it’s only since investors woke up to the harsh new realities of lower expected returns that they’ve been pursuing these strategies in earnest.

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In these strategies, investors try to find consistent sources of alpha — the risk-adjusted return above a set benchmark. They short out the market exposure of the alpha source, and then port the alpha onto a readily available market exposure, or beta, usually through a derivatives contract.

For example, a pension executive might believe a small-cap equity manager can produce alpha while large-cap equity managers cannot because pricing of large-cap stocks is very efficient. The fund would hire the small-cap manager, short the Russell 2000 index, and then port the alpha onto a Standard & Poor’s 500 index strategy, such as an exchange-traded contract, a futures contract or a swap.

Among those building up their portable alpha programs:

• International Paper Co., Stamford, Conn., whose $6.6 billion pension fund plans to expand its $330 million program, said Robert Hunkeler, vice president for investments;

• The $1.4 billion Wisconsin Alumni Research Foundation, Madison, which is in the process of developing separate portfolios of alpha sources and beta sources, said Tom Weaver, director of investments;

• Bedrijfstakpensioenfonds Metalektro, Schipol, Netherlands, which plans to increase the portion of its risk budget dedicated to portable alpha to 30 to 40 basis points on the entire e16 billion ($19.5 billion) pension fund, up from 10 to 15 basis points now, said Paul van Gent, portfolio manager.

• The $3.1 billion University of Virginia endowment, which plans to use portable alpha strategies as a way to keep beta exposures in line with the fund’s newly revised investment policy while seeking to maximize alpha, said Christopher Brightman, chief executive officer for the University of Virginia Investment Management Co., Charlottesville, Va.

Jumping on bandwagon

The nation’s biggest pension funds are jumping on the trend. According to a survey by JPMorgan Asset Management, New York, 33% of large U.S. corporate pension funds already use portable alpha strategies, while 23% are considering adopting such strategies.

Only 15% of public funds employ such strategies, although a staggering 37% are weighing their adoption, according to the survey of 120 of the top 350 U.S. pension funds (Pensions & Investments, May 16).

Most pension funds have relatively small allocations to portable alpha strategies, experts said. “The most sophisticated clients are doing it in size, and moving in that direction very quickly,” said Mark Carhart, managing director and co-chief investment officer of the quantitative strategies group at Goldman Sachs Asset Management, New York.

Investors are looking to a variety of sources to find alpha. Mostly, they’re turning to hedge funds. But they’re also using short- and long-term duration strategies, Treasury inflation-protected securities, currency absolute-return strategies and global tactical asset allocation strategies.

Joe Nankof, a partner at Rocaton Investment Advisors LLC, Norwalk, Conn., said his firm divides alpha sources into three categories: arbitrage strategies, such as merger arbitrage and convertible arbitrage; macrolike strategies, such as global tactical asset allocation; and securities selection, including equity market-neutral, long-short, distressed debt and credit long-short.

In the past 2 1/2 years, Rocaton has been de-emphasizing arbitrage strategies because of their limited capacity and the amount of money flowing into those strategies, he said.

The International Paper fund has had a portable alpha program in place for two years, using three hedge funds of funds to generate alpha. The hedge fund alpha is ported onto a Standard & Poor’s 500 index overlay managed by NISA Investment Advisors LLC, St. Louis.

Since inception on June 1, 2003, the managers — UBS O’Connor LLC, Chicago; Ramius Capital Group LLC, New York; and Blackstone Alternative Asset Management, New York — collectively have met the low end of the fund’s return expectations of outperforming the S&P 500 index by two to four percentage points, Mr. Hunkeler said.

At $330 million, the program represents one-fifth of the fund’s equity exposure. Mr. Hunkeler said he plans to increase the program but declined to provide specifics.

Complexity grows

As use of portable alpha strategies has become more widespread, the strategies themselves have become more complex. Instead of picking one source of alpha and transporting it onto an asset class that is viewed as very efficient, such as U.S. large-cap stocks or fixed income, some institutions are completely separating alpha from beta — in effect, running them as two separate portfolios.

“Today, it’s separating the alpha and beta portfolios completely, having two different portfolios that have no relationship to each other,” Mr. Carhart said.

The Wisconsin Alumni Research Foundation is doing just that. Mr. Weaver said he’s building a portfolio of alphas and a portfolio of betas. He plans to have eight different managers in his alpha pool.

Bridgewater Associates Inc., Westport, Conn. is unusual in being in both portfolios: the fund invests in Bridgewater’s pure alpha fund, as well as its “All-Weather” portfolio, which provides beta exposure. The fund also uses the Clifton Group, Minneapolis, for overlays and rebalancing. Mr. Weaver declined to provide more detail.

Hard to pick alpha

Many experts say, however, that portable alpha strategies require institutional investors to be astute in picking their managers and can be expensive to implement.

William Jacques, chief investment officer at Martingale Asset Management, Boston, said some investors are intrigued with the prospect of picking hedge fund managers that can generate a 500-basis-point premium over Treasury bills, and porting that return onto an equity-index return.

“But I think some people confuse the two: they think the 500 basis points in hedge fund alpha is something that is highly likely, whereas it’s highly unlikely to get a bunch of managers who will get 500 bp” from skill-based returns, he said.

Rick Dahl, chief investment officer of the $6.5 billion Missouri State Employees’ Retirement System, Jefferson City, agreed. “Our view is that finding alpha is a very difficult thing to do, especially in a marketplace where people are of the belief that returns from the traditional stock and bond universe are going to be in the mid-single digits at best.

“All that everybody wants to do is talk about alpha. But the reality is that for every winner in this game of alpha, there’s a loser. And, net of all the fees that are being paid, our research suggests that there are probably more losers than there are winners,” he said.

Mr. Dahl said some pension executives seem to think that the availability of hedge funds is going to increase their chances of generating alpha. But he believes “the more money that flows into these strategies, the more difficult it’s going to become.”

The key to generating alpha, he said, is finding skillful managers and “giving them the freedom to think very broadly about how to make money.”

Mr. Dahl was reluctant to discuss details of MOSERS’ investments, but he did acknowledge that more than 20% of the total fund is invested in portable alpha strategies. He said Bridgewater is a manager but declined to discuss others.

MOSERS has a number of strategies that are often used to provide alpha in portable alpha strategies.

As of June 30, 2004, the fund had $336 million invested with 20 hedged equity managers, according to the fund’s fiscal 2004 annual report. The fund also had $343 million invested with 36 market-neutral managers.

The Missouri fund also had $202 million invested in an enhanced Goldman Sachs Commodities Index portfolio managed by NISA Investment Advisors. Several experts noted many plan sponsors port alpha onto commodities indices.

Costly implementation

The costs of hedging the beta also can be significant, sometimes eliminating the alpha, said Deb Boedicker, principal, Strategic Investment Group, Arlington, Va., which assembles hedge funds of funds for its clients.

Gordon Latter, pensions and endowments strategist at Merrill Lynch, New York, quantified those costs in a recent paper published by the firm. He noted that exchange-traded funds, futures contracts and total return swaps are used in executing portable alpha strategies. But costs can vary significantly. For example, shorting the Russell 2000 index costs about 80 basis points but can range from 30 basis points to 130 basis points.

“However, at certain times, demand is so great, such as in May or June when the Russell 2000 is reconstituted, this could easily exceed 150 bp. Thus, the timing of when to execute a portable alpha trade is vital,” he wrote.

Nor is it simple to strip out the market effect from hedge funds, said one corporate pension executive, who asked to be unnamed. Say the pension fund invests $1 million with a hedge fund benchmarked to Treasury bills and that has a stock market beta of 0.4. At first glance, one might short 40% of the exposure, or $400,000. But if the hedge fund manager is leveraged five to one, then a $400,000 short might not be the correct market exposure, he said.

“What I find strange is that people focus on that term ‘hedge fund’ and don’t look at the total result. Have you managed to minimize the cost? Have you picked things that produce excess return at the total fund level? When people focus on that, they might ask whether some hedge funds are delivering,” said Mr. van Gent of the Dutch metalworkers’ fund.

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