Bachelor Arbeit "A Portable Alpha Strategy’s Implementation"
1 Introduction
As it is in the nature of every rational investor to maximize one's profit, the finance community is always eager to acquire additional revenue by implementing creative and state-of-the-art financial models. On the basis of milestones in financial theory, such as the Modigliani-Miller theorems, the modern portfolio theory2 and the CAPM3, the concept of portable alpha strategy arose.
Whilst traditional approaches depend on long-only strategies, portable alpha strategy enables an investor the opportunity of going long on assets and selling them short simultaneously (Coates et al. 2006).
Portable alpha was first introduced in the beginning of the 1980s (Brown N.D.) and is based on the conception that alpha and beta are separable. As one separates the alpha from the beta and then transfers the extracted alpha to other portfolios within a portable alpha strategy, one is able to maintain the portfolio's existing strategic asset allocation (Kung et al. 2004). At this conjuncture alpha replicates the excess return one generates, whereat beta replicates the return obtained through market exposure. Since the strategy of portable alpha was more and more accepted and the concept succeeded (Coates et al. 2006), the application of portable alpha strategies increased and major investment firms as BlackRock, PIMCO and other important asset managers adapted to the trend and provided products containing those strategies (Nesbitt 2008).
The objective of the work at hand is to explain the theoretical basics and the concept behind portable alpha strategy, followed by an implementation onto a created portfolio and a subsequent analysis. Chapter 2 will define the term portable alpha and give an overview of what portable alpha is. Moreover, the portable alpha approach is compared with the traditional approach. On the basis of the comparison, advantages and drawbacks will be discussed. In chapter 3 the main sources of alpha will be illustrated by having a look at equity as well as fixed-income markets and hedge funds. Last mentioned will be examined more thoroughly, in regard of generating market neutral return. Subsequently chapter 4 compares the impact of different funding methods for portable alpha strategies. Chapter 5 will have a look at derivatives, later being used to obtain the possibility of using portable alpha strategy and hedging its market exposure.
1
The Modigliani-Miller theorem of Franco Modigliani and Merton Miller states as their general concept,
that a company's firm value is unaffected by its capital structure.
2 The modern portfolio theory deals with optimizing or maximizing expected return based on a given level of risk.
3 The CAPM calculates the expected return of an asset, with regard to an investor's risk preference towards the market portfolio.
Chapter 6 will clarify the basics of implementation, before implementing a portable alpha in chapter 7 and comparing the obtained result with an in chapter 4 created portfolio. Finally chapter 8 concludes the work and gives an outlook of possible enhancements for making the portable alpha approach more efficient.
2 Theory of Portable Alpha
According to finance theory, active managers provide two types of return: alpha and beta (Kung et al. 2004). Beta is a sensitivity measure of a portfolio's or security's systematic risk respectively volatility. According to the CAPM, multiplying beta with the risk premium'', one obtains the return that is generated through market exposure (Bodie et al. 2014). Beta is not only achieved by active investment management, but also by passive investment management, whereas, alpha is derived by active managers, who believe in the possibility to outperform the market. Alpha depends on the manager's skill or the manager's luck in picking stocks (Iverson 2013). It measures the excess return, which is not embodied through beta exposure; a positive alpha indicates that the manager has beaten the market, whereas a negative alpha indicates that the manager underperformed the market (Ali 2005). Both terms are highly interrelated and it is essential to understand both terms accurately for the theory of portable alpha (Callin 2008).
2.1 What is Portable Alpha?
Portable alpha is still a new development in investment management; despite being first introduced in the early 1980s, shortly after thirty-year U.S. Treasury futures were introduced (Labuszewski et al. 2013) (Callin 2008). Its acceptance and implementation increased over the years, evidenced by the growth of portable alpha applications as well as an increasing number of investors having applied the concept of portable alpha in a variety of sizes to either part or all of their investment portfolios (Coates et al. 2006). According to following statement in 'Index Appeal' of Lee Thomas, former PIMCO Managing Director and senior global strategist, the portable alpha strategy is a revolutionary process in investment management:
"My sense is that the world is pregnant for a revolution in investment management. It feels like 1935, when people knew that the current macroeconomic thinking didn't work and then Keynes published his General Theory. The separation of alpha and beta is similarly powerful. [...] "
Until now several definitions and explanations describing portable alpha arose, confusing the global finance community what portable alpha is and what not. According to aforementioned Lee Thomas as well as Kung et al. (2004) and Ezrati (2006), portable alpha refers to the process of deliberately separating the alpha from the beta and then applying it onto beta providing portfolios. This might be a combination of an alpha providing hedge fund with an index, such as S&P 5005, DAX6 or Nikkei 2257. There are, however, a lot of different sources from which one can extract the alpha, as well as there are a broad variety of asset classes to implement a portable alpha. Once alpha is derived, it is efficient and feasible to transport portable made alpha to several asset classes simultaneously (Coates et al. 2006). Not only due to the separation of alpha and beta, the portable alpha strategy approach differs from the traditional approach in various ways. Therefore, we will have a look at the differences of both approaches.
2.2 Traditional Approach vs. Portable Alpha Approach
The traditional approach is a two-step process. At first, an investor needs to decide on how to allocate one's investment budget onto the assets. Secondarily, the investor must decide how much to invest actively and passively, before choosing the best active manager in each asset category, who is able to generate positive alpha within the underlying asset class (Callin 2008). Due to the focus on each asset class separately, the variety of strategies and different managers is limited and alpha might not be chosen from the best and most reliable sources (Coates et al. 2006). As a result of the traditional approach, the alpha and beta of each asset class are bundled together in one portfolio (Ezrati 2006), the portfolio return being the sum of the market return and the alpha return from the same asset class (Klein et al. 2005).
In contrast, with portable alpha strategy asset class decisions and alpha manager selection are made independently, with caution of choosing these managers providing the best and most reliable alpha. Being able to select managers independently, investors obtain the possibility to choose from a much broader variety of alpha managers. Once the best alpha managers are identified, with regard to liquidity needs and risk, the
5 The S&P 500 is a capitalization-weighted index of 500 large U.S. companies. 6 The DAX is a capitalization-weighted index of 30 large German companies The Nikkei 225 is a price-weighted index of 225 large Japanese companies.
portfolio's embedded betas are assessed (Coates et al. 2006). Subsequently the portable made alpha is implemented through an overlay or by strategic asset allocation in order to target the desired total asset dispersion. Overlay or leveraged strategies use little or no cash by using futures, options or swaps. Within strategic asset allocation one can either allocate all capital to the portable alpha, however, this might not be viable due to guidelines and constraints or one can allocate parts of the capital to a portable alpha strategy while maintaining the original asset allocation structure by using futures or swaps (Kung et al. 2004). The key behind all alpha implementations is diversification by creating a market-neutral, respectively a beta neutral, portfolio (Oderda 2007) (Kung et al. 2004). Market neutrality in this context means that the portable alpha generates returns, which are uncorrelated to the asset class it is transferred onto (Patton 2009). Combining both parts, portable alpha and beta, the aim is to generate an attractive risk-adjusted excess return in addition to the market return (Callin 2008). As a result of the portable alpha approach, the total portfolio's total return is the sum of the benchmark / beta return and the portable alpha return, including the embedded beta as shown in Figure 1, if not totally hedged out (Klein et al. 2005).
2.3 Advantages and Drawbacks
Despite its challenging implementation, portable alpha strategy obviously has to offer essential benefits compared to the traditional investment approach, yet all strategiesinvolve risk and pitfalls. Given the fact, that both approaches execute different techniques and procedures, the first key benefit for investors is the possibility of exploiting alpha from a much broader variety within a portable alpha strategy than traditional investors can. While traditional investors have to seek alpha within the underlying asset, investors of portable alpha strategy obtain the possibility to source alpha from literally speaking every alpha-generating source. Subsequently, if alpha is extracted, one can apply the portable made alpha to any desired benchmark or asset. This increase in efficiency by choosing alpha without regard to its asset class can lead to substantial economies of scale, as one portable made alpha is transferred to several benchmarks simultaneously (Coates et al. 2006). The theory of identifying, extracting and transferring the portable alpha to the desired benchmark might sound easy, however, it is challenging and it demands high-level risk management capabilities as well as high-level product knowledge (Oderda 2007). It is a common misperception, that once alpha is identified and extracted, it can be ported to any desired benchmark. Another misperception is, that alpha can easily be extracted by creating a beta neutral portfolio using derivatives. Moreover, it is necessary that investors carefully and continually consider the functionality of obtaining market exposure to employ a portable alpha strategy (Callin 2008).
Furthermore, with portable alpha strategy it might be easier to accomplish exploitation of diversification effects, while combining with each other uncorrelated asset classes. This is on grounds of sourcing alpha independently from the desired market exposure.
Another major point in the alpha generating process is risk management, the most important element in investment management as Benjamin Graham, a former professional investor, once stated:
"The essence of investment management is the management of risks, not the management of returns."
Due to a direct connection between alpha and the underlying asset class within a traditional investment approach, both risk exposures are interconnected. Portable alpha strategy, whereas, pursues the goal of combining with each other uncorrelated portfolios by extracting total market exposure from the portable alpha and than transferring generated market neutral alpha to the desired benchmark. The incentive behind risk budgeting is an increase in returns while maintaining the same risk profile respectively adding minimal risk (Callin 2008) (Coates et al. 2006).
Moreover, it is expected that within a portable alpha strategy investors pay lower fees in total, even though larger costs for alpha-generating managers emerge. These costs are based on continual changes within the most attractive alternative strategies that result in a permanent alpha manager's quest for the best and most innovative ideas. This quest as well as the process of locating, analyzing and accessing for alpha investments is very access-, labor- and skill-intensive. Even if there are higher fees for skilled managers who really reckon alpha, fees for beta exposures are much lower, since monitoring these is not needed as precisely as compared to monitoring and controlling alpha in a portable alpha approach (Coates et al. 2006). Despite risk management for beta exposures is regarded as simpler, it is as essential in a portable alpha strategy as risk management for the portable alpha by itself. Therefore, to maximize profit of one's portfolio, the investor should not neglect costs for proper beta management (Callin 2008). Yet one has to be aware of the fact, that high costs can decrease the portfolio's efficiency.
Although excess returns seem attractive, especially the return of market-neutral hedge funds; blind trust in manager activities is not the best option. Investors have to be aware that paying alpha fees for managers does not implicate obtaining true alpha. (Jensen et al. 2003 quoted according to (Kung et al. 2004)) evidenced in their working paper that several manager repacked beta and sold it as alpha. Moreover, Gain et al. (2005) stated, based on a performed study during January 1999 and December 2004 that only 25% of the variability of hedge fund returns and 4% of the performance of hedge funds is defined by pure alpha.
2.4 How to create Market-Neutrality
Due to a challenging sourcing and implementation process of a portable alpha strategy, one may look at an easy theoretical framework in advance to understand the basics behind the process. Therefore, we will have a look at a simple market-neutral example in which alpha is made portable while the embedded beta exposure within the portable made alpha is hedged.8
Suppose you are a manager of a $2.0 million portfolio. Based on your predictions that on the one hand the market will fall, thus rM < 0, and that on the other hand a specific stock is underpriced and you recognize a possibility to beat the market, thus a > 0, you aim for isolating the alpha from the stock's beta by hedging the beta exposure.
8 Following example is based on Bodie et al. (2014).
Moreover, we assume that we can calculate our investment's expected return via the CAPM formula:
ri = rf + grm — rf) + e + a
where the notation is as follows: ri is the return on security (i), rf is the risk-free rate, rMis the return on market portfolio (M), fli is the security's beta, e is the residual term and a is the security's alpha.
For the sake of convenience we assume that rf = 0.005, fli = 1.6, a = 0.03, the current value of the S&P index is 2,133, and that the portfolio pays no dividends. Due to above-mentioned aim of isolating the alpha of 3% per month, you hedge your beta exposure by going short on S&P 500 future contracts. The needed number of future contracts is derived by the hedge ratio; comparing the size of the portfolio (position being hedged) and the size of the total position:
N* = NA—ri * fli
QF
where the notation is as follows: N* is the hedge ratio, NA is the value of the portfolio, QF is the size of the total position and fli is the security's beta.
The S&P 500 multiplier of $250 results in a one month hedge ratio of 6 short future contracts; simplified in the following example by maturity matching of the future contracts and the hedging horizon to 1 month:
2,133 * $250 * 1.6 = 6 contracts The expected value of the portfolio after 1 month will be:
$2,000,000 * (1 + rpF) = $2,000,000 * [1 + .005 + 1.6(rM — .005) + .03 + e]
= $2,054,000 + $3,200,000 * rM + $2,000,000 * e
The proceeds from the futures position will be:
6 * $250 * (F0 — F1) Mark to market on 6 contracts sold
= $1,500 * [S0(1.005) — Si] Substitute for futures prices
= $1,500 * So [1.005 — (1 + rM)] Because S1 = So (1 + rM); due to no dividends
= $1,500 * [so( 005 — rM)] Simplify
= $16,000 — $3,200,000 * rM Because So = 2133
Summing the portfolio value and the futures proceeds at the end of 1 month equal the final stock value plus futures positions:
Hedged process = $2,070,000 + $2,000,000 * e
By combining both equations, the market exposure respectively beta exposure is completely eliminated. The expected return after 1 month equals 3,5%, which is the sum of alpha (3%) and the risk-free rate (0.5%), plus the return of the residual term, that is e. Once you hedged the market risk, you can combine alpha with other asset classes, such as different indexes or ETFs. However, one has to be aware of the fact that above-mentioned theoretical example is still risky in reality.
3 Sources of Portable Alpha
Selecting an optimal alpha engine is the important first step in a portable alpha strategy's process that is followed by analyzing, investing and monitoring (Coates et al. 2006). Due to the fact that hedging out portable alpha's market risk in reality is not as simple as it is displayed in above-mentioned example and especially due to steady increasing possibilities of sourcing alpha, we will take a more precise look on markets where alpha is sourced. The following chapter provides three of the main alpha sources (Figure 2), that reach from low-risk fixed-income investments to higher-risk hedge fund investments that can be either implemented via an overlay or by strategic asset allocation (Kung et al. 2004).
3.1 Equity Markets
Generally speaking, in equity markets or stock markets, shares of publicly listed companies are traded and issued either through organized stock exchanges9 or OTCmarketsi° (Madura 2012). Due to higher expected returns of equity investing, compared to conservative investing, e.g. bonds, equity investing is compelling for investors who seek to gain additional return from their equity investments by managing one's portfolio actively (Callin 2008).
With regard to portable alpha strategy and stock selection process, investor's intention is to invest in undervalued stocks while selling overvalued stocks (Madura 2012). The stock valuation process relies on fundamental, technical, or quantitative analysis (Callin 2008). By evaluating all publicly available information with either a top-down or a bottom-up approach within the fundamental analysis, a manager tries to achieve detailed background knowledge of the underlying company. Bottom-up analysis is based on company-specific attributes, whereas top-down analysis deals with macroeconomic attributes (Grimm 2012). Within technical analysis, manager search for periodical and predictable stock prices by analyzing records or charts of historical trends (Bodie et al. 2014). The random walk implication of the efficient market hypothesis " contradicts technical analysis by stating that stock prices cannot be predicted, rather future stock prices are independent of past prices and follow a random process (Mishkin et al. 2015). While previous analyses claimed profound company knowledge or stock prices characteristics from a manager, within quantitative analysis a manager totally relies on statistics by comparing security's behavior with mathematical and computer-based statistical models (Callin 2008).
More recent strategies enable a manager greater investment freedom by involving long/short strategies that reach from 100 percent long to 100 percent short on a pair of stocks within the same industry. Such a combination can be achieved by investing 130 percent long and 30 percent short (Callin 2008).
9 Organized stock exchanges are marketplaces of securities where purchasers and sellers are able to trade
stocks under regulatory supervision; for instance NYSE.
io
At OTC-markets stocks are traded between two parties, without the supervision of exchanges; for
instance Nasdaq.
11 Professor Eugene Fama (University of Chicago) developed the concept of the efficient market hypothesis. It states that the market incorporates and reflects all relevant information about stocks and stock markets without delay. Therefore, shares are traded always at their fair value and it exists no possibility to outperform the market.
3.2 Fixed-Income Markets
According to Figure 2 fixed-income investments are the main alpha source. Despite the fact, that every investment features risky components, the as predictable and reliable viewed fixed-income investments, generating returns above "cash" or money market investments value, mostly bonds, while exhibiting little downside risk and being mostly liquid. In the majority of cases, the expected return can be explained by key market risk factors, such as duration and yield curve (Callin 2008). Moreover, to benefit from diversification effects in portfolio management, bonds and stocks were often combined within one portfolio based on their low, respectively, even negative correlation, especially throughout much of the 20th century. Even though correlation rose since the late 1990s, a combination of both still offers to use potential diversification effects (Rankin et al. 2014). Based on the emerging diversification possibilities, fixed-income investments are not only in a portable alpha strategy's context immensely popular among investors (Callin 2008).
Especially global fixed-income markets facilitate interesting benefits of alpha opportunities for investors while reducing volatility of returns due to international diversification. An essential part in this context is a currency-hedged allocation to global bond markets in order to cover potential currency changes. Although theory still argues whether benefits of global diversification still exist or have been diminished in recent years, practice proves that those benefits still remain (Callin 2008).
3.3 Hedge Funds Strategies
A Hedge Fund Research by KPMG (2012) implies that hedge funds record a continuous and steady growth, despite the industry has being affected by a rough drop of estimated assets during the financial crisis as shown in Figure 3. Moreover, according to HFR (2015), assets under management even grew to $2.97 trillion during the second quarter of 2015. The number of hedge funds in the industry has grown simultaneously from 530 in 1990 to 7,164 at the beginning of 2011 (Athanassiou 2012). This results from a broader group of investors, which is not just based on institutional investors anymore, but also on public and private pension plans, foundations and other admitted investors. All of them seek to gain attractive returns as well as diversification and volatility benefits by including hedge funds and funds of hedge funds instead of other risky assets or investments in their portfolio (Callin 2008).
Figure 3: Volume of Hedge Funds / Performance of Hedge Funds Source: KPMG (2012)
In general, the term hedge fund describes a private actively managed investment pool that is in most instances exempt from SEC12 regulation (Bodie et al. 2014). Not being forced to follow the SEC regulations, managers are capable of employing nontraditional trading techniques, meaning they can go long on underpriced (` good') stocks while short-selling overpriced (`bad') ones simultaneously. Therefore, combining long and short components, a portfolio manager can hedge the portfolio's risk more efficiently (Athanassiou 2012).
However, a recent research by Guesmi et al. (2014) stated that hedge funds are extremely volatile in times of a financial crisis such as the Asian crisis in 1998 or the recent financial crisis in 2008. Gorton et al. (2012) strengthened previously mentioned statement, that especially hedge funds played an important role in the financial crisis in 2008. Therefore, it is not only essential within portable alpha strategy to understand the underlying risks when choosing hedge funds for alpha sourcing. Due to limitations of quantifying possible extreme losses of hedge funds' standard risk measure techniques as VaR or volatility, better measurements were needed to predict potential extreme losses more precisely. These limitations arise from specified normal or regular distribution, which just state potential losses without strict regard to potential extreme situations accompanied by tremendous losses. To solve those limitations more effectively, risk management solutions, such as stress testing as well as a modified VaR, that embraces higher moments and co-moments of non-normal distributions, were introduced (Callin 2008).
Regarding portable alpha strategies, which aim to combine with each other uncorrelated parts of alpha and beta, hedge funds or funds of hedge funds are regarded as an attractive alpha source due to their low correlation with important market indices and their superior performance compared to equities and bonds as illustrated in Figure 3. Table 1 shows the correlations of all CSFB Hedge Funds with important market indices during the time period 04/1994 to 2003. It is necessary to be aware of the fact that market neutrality does not implicate beta neutrality as it is implicated by the positive correlation of the CSFB Market-Neutral index with the S&P 500 index. Furthermore, not every alpha source from alpha-generating hedge funds is appropriate for the usage as portable alpha due to a challenging extraction of the market risk or systematic risk while maintaining market neutrality (Kung et al. 2004).
Correlation Analysis - 1994-4/2003
SP500
EAFE
Lehmann
AgG
Non US
Bond
RE
Cash
CSFB Hedge Fund Index
CSFB Multi Strategy CSFB Emerging Market CSFB Fixed-Income Arbitrage Index
CSFB Global Macro
CSFB Managed Futures CSFB Short Bias
CSFB Market-Neutral Index
CSFB Event-Driven
CSFB Convertible Arbitrage Index
CSFB Hedged Long/Short Index
0.46
0.04
0.47
-0.01
0.22
-0.26
-0.76
0.40 0.54 0.11 0.57
0.41
0.09
0.48
0.00
0.11
-0.13
-0.64
0.34 0.52 0.07 0.57
0.14
0.02
-0.13
0.07
0.24
0.30
0.10
0.06 -0.05 0.07 0.05
-0.20
0.09
-0.27
-0.22
-0.22
0.35
0.09
0.03 -0.21 -0.21 -0.02
0.24
0.11
0.27
0.21
0.17
-0.09
-0.27
0.24 0.39 0.20 0.22
0.10
0.09
-0.07
0.03
0.08
-0.08
0.05
0.25 0.10 0.14 0.10
Table 1: Correlation Analysis of CSFB Hedge Funds with Indices 04/1994-2003 Source: Own creation according to Kung et al. (2004)
Due to the outdated research, I renewed the data for the time period 07/2010-06/2015 to see if hedge funds still offer market-neutral possibilities. Table 2 shows the correlations of all CSFB Hedge Funds with few selected important market indices. Despite the fact that some different indices and a shorter time period are being used to compare data, it shows that during the research time period the returns of indices were mostly negative correlated to hedge funds. Therefore, indices with negative correlation to several hedge funds enable the investor's options for diversification effects. While Barclays Capital U.S. Aggregate Bonds mirrors this result with simultaneously having strong negative correlations to several hedge funds, the DAX reflects the total opposite. Based on either strong positive or negative correlations, hedge funds did not provide perfect alpha opportunities during this time period as they fluctuate with or against the market.
Correlation Analysis - 07/2010-06/2015
S&P
DAX 500
Nikkei 225
S&P GSCI
Barclays
Bonds
CSFB Hedge Fund Index
0,95
-0,65
-0,35
0,39
-0,94
CSFB Multi Strategy
0,90
-0,48
-0,04
0,15
-0,81
CSFB Emerging Market
0,90
-0,13
0,20
-0,22
-0,57
CSFB Fixed-Income
Arbitrage Index
0,09
-0,53
-0,18
0,43
-0,41
CSFB Global Macro
0,54
-0,91
-0,73
0,69
-0,89
CSFB Managed Futures
-0,09
0,66
0,52
-0,76
0,49
CSFB Short Bias
-0,98
0,55
0,26
-0,32
0,89
CSFB Market-Neutral
Index
0,80
-0,56
-0,24
0,19
-0,80
CSFB Event-Driven
0,91
-0,66
-0,44
0,52
-0,92
CSFB Convertible
Arbitrage Index
0,51
-0,92
-0,61
0,68
-0,88
CSFB Hedged Long/Short
Index
0,94
-0,60
-0,25
0,37
-0,91
Table 2: Correlation Analysis of CSFB Hedge Funds with Indices 07/2010-06/2015 Source: Own creation; Data: Bloomberg, CSFB Hedge Funds
4 Funding Portable Alpha and its Impact
As we got a view on different alpha sources, we will now look at three different funding possibilities for an investor of a portable alpha strategy, as described by Kung et al. (2004). Furthermore, I constructed a portfolio13 with an asset mix consisting of 36% S&P 500, 23% DAX, 7% Nikkei 225, 13% S&P Goldman Sachs Commodity Index and 21% Barclays Capital U.S. Aggregate Bond Index to analyze the impact of these funding options. Throughout this paper, we will refer to the above-mentioned as "the plan". Based on the plan, I created 16 distinct portfolios, step-by-step replacing 5% of fixed-income and volatile viewed equity, followed by replacing both in equal parts. To analyze its impact on risk reduction and alpha enhancements, I used the CSFB Market-Neutral Hedge Fund as the replacement. Moreover, I proportionally scaled down the overall allocation of the plan and substituted the removed parts with the above-mentioned hedge fund. Table 3 illustrates the course of action on the basis of replacing
13 The portfolio consists of five indices. All data of indices replicate total returns, so that further potential dividend payments as well as coupon payments can be omitted. Moreover, all indices are converted into EUR; hence no further FX adjustments are required. Furthermore, for achieving convincing and significant data, data series are harmonized.
each approach with 5% of CSFB's Market-Neutral Hedge Fund. Figure 4 indicates the goal of reducing risk being achieved due to the negative correlation of CSFB Market Neutral Index to most indices. The result of reducing risk is achieved in every one of the above-mentioned scenarios, despite that the portfolio's enhancements could not be achieved with hedge funds during the research period. This is based on high market returns compared to lower hedge funds returns. However, it is shown how to fund portable alpha while changing the asset allocation.
Plan
5% S&P
500
5%
Barclays
Bonds
5% Both
Scaling
Down
DAX
23,00%
23,00%
23,00%
23,00%
21,85%
S&P 500
36,00%
31,00%
36,00%
33,50%
34,20%
Nikkei 225
7,00%
7,00%
7,00%
7,00%
6,65%
S&P GSCI
13,00%
13,00%
13,00%
13,00%
12,35%
Barclays Bonds
21,00%
21,00%
16,00%
18,50%
19,95%
Market-Neutral
Index
0,00%
5,00%
5,00%
5,00%
5,00%
Sum of
Weightings
100%
100%
100,00%
100%
100%
Expected Return
12,14%
11,23%
11,86%
11,54%
11,57%
Standard Dev.
3,83%
3,46%
3,39%
3,41%
3,58%
Table 3: Course of Actions while Adding 5% Market-Neutral Index Source: Own creation; Data: Bloomberg, CSFB Hedge Funds
5 Derivatives-Based Beta Management
For further study and the implementation of portable alpha, we will now look at derivatives, which are mostly used within portable alpha strategies. Futures and swaps are the two basic hedging instruments used to eliminate market exposure in a portable alpha strategy without using additional capital (Kung et al. 2004). Although it is said that index management as well as derivatives-based beta management in a portable alpha context is not as challenging as managing alpha and therefore costs should be lower, it involves risky components like any other investment. Those need to be controlled and monitored as precisely as it is done with alpha in order of an all in all successful investment. It would be careless to neglect associated risks as derivatives-based beta takes a central role as the building block within the portable alpha strategy (Callin 2008).
5.1 Futures
The usage of derivatives, in particular futures, is the most suggested advance to above-mentioned exposure elimination; hence we take a look at the basics of futures. By agreeing to a futures contract a buyer (seller) is bound by contract to buy (sell) a certain standardized commodity for a predetermined price at the execution date stipulated (Mishkin et al. 2015). For potential financial losses and the ability to continue doing futures contracts' business, one has to meet several requirements. At the beginning a minimum initial margin has to be banked which is elementary to enter a futures contract in the first place. Meeting these first capital requirements, one has to meet the maintenance margin, which is the minimum that is required to maintain within one's account to continue running futures positions. If the equity in the trading account reaches this level or falls below, one is required to rebalance the account to the initial margin within a predetermined time, via a margin call. If one is not able to meet those payments without delay, a futures commission merchant14 will liquidate the futures' position. If futures are settled at the execution date futures can either be settled financially15 or physically16 (Dubofsky et al. 2002). Mainly, futures contracts are exhibited from companies or producers with the incentive to decrease risk as far as
14 A futures commission merchant is an individual or a firm that solicits or accepts orders for commodity contracts traded on the futures contract market.
15 Financially settlement is a cash delivering of the underlying asset.
16 Physically settlement is the delivering of the underlying asset.
possible by executing short hedges or to bet on price fluctuations by executing long hedges (Hull 2012).
5.2 Swaps
Besides the usage of futures, also swaps, which also require small cash reserves, are widely used to transport alpha from one asset class to another (Nesbitt 2008). Figure 5 shows that the total volume of swaps, which combines the volume of interest rate swaps, currency swaps and interest rate options, steadily grew, despite a rough drop during the financial crisis (ISDA 2010). Within a swap agreement two counterparties agree to exchange uncertain cash flows. These cash flows are defined by interest rates, exchange rates or the prices of indexes or commodities. Compared to futures, cash flows are exchanged periodically depending on the predetermined future date (Dubofsky et al. 2002). Due to emerging counterparty risk if swap positions fluctuate, counterparties agree to close the ISDA Master agreement" to minimize risk (Callin 2008).008)
1. The alpha strategy investment
2. The derivatives-based market exposure
3. Liquidity for margin or collateral calls
4. Consolidated risk management, risk monitoring, and reporting
Although in reality more approaches exist, three main categories can be formed: fully integrated, completely segregated, and a mix of both, being called semibundled. As with all investing, it is essential that investors are aware of advantages and disadvantages of each approach as well as the approach's complexity, costs and risks (Callin 2008).
6.1 Implementation Elements
The first two topics were already discussed in previous chapters; therefore we take a closer look at the two last-mentioned, before heading to the implementation process itself. Liquidity is essential for meeting margin or collateral calls within derivatives-based market exposure due to liquidity needs of derivative's financial instruments. If the financial cushion is exhausted and further money cannot be reached, liquidation of the beta exposure will immediate, which can have tremendous negative effects on your investment, if beta exposure takes a key part in your investment. Therefore, an alert investor supervises liquidity units carefully within portable alpha strategy (Callin 2008).
Consolidated risk management, monitoring and reporting, define the last and often neglected part of the implementation process, however, being as essential as the other parts if alpha and beta are managed separately. Managing beta exposure and alpha strategy separately, a continuous exchange of insights in changes regarding the underlying material value is required for a successful implementation as well as a thorough risk understanding of both separately managed processes (Callin 2008).
6.2 Implementation Approach 6.2.1 Integrated Approach
Within an integrated approach, one manager is in charge of all four elements. Therefore, from an investor's point of view an integrated approach, in which one manager is responsible for the whole portable alpha strategy, is best manageable. By ambition of both parties, investors and managers, aiming for attractive risk-adjusted returns respectively attractive fees, manager's incentives meet investor's goal. Moreover, as a result of integrating all steps within one portable alpha provider, operational and investment risk is easier to observe compared to following approaches. An investor has to be aware of the fact, however, that sticking to one provider limits the possibilities of different offerings (Callin 2008).
6.2.2 Segregated Approach
Whereas with integrated approach one manager is responsible for all sections, segregated approach splits all elements so that each of the four elements is managed solely. Moreover, investors are fully integrated in implementation process, they are responsible for possible liquidity needs and consolidated risk monitoring and reporting, if not hiring an external party for doing so. An investor benefits from possessing the potential to freely choose alpha and beta provider. However, it requires good communication and interrelated costs as well as appropriate risk controls (Callin 2008).
6.2.3 Semibundled Approach
A semibundled approach is roughly said a mixture out of the other two approaches. In the first place, all elements are separately managed in the way it is done within the segregated approach. Subsequently, a central provider acts as a connecting point between investor and the different element managers and bundles all elements for the investor. Similar to segregated approach, one has the option of a broad variety of alpha strategies. Furthermore, one benefits if a centralized provider controls all actions. Counter-arguing, however, costs are extremely high by combining a total segregated approach and a central provider and complexity of legal documentation arises (Callin 2008).
7 Implementation
Average alpha of JP Morgan Funds
01/2011 - 12/2014
01/2012 - 12/2014
Small Cap Core Fund
2,90%
4,00%
Small Cap Growth Fund - Select
-0,78%
-0,88%
Small Cap Value Fund - Select
1,51%
1,48%
Large Cap Growth Fund - Select
-1,47%
-2,04%
Large Cap Value Fund - Select
-0,48%
1,09%
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