Portable alpha mania?

Portable alpha? Why should investors "port" new sources of return onto old sources of return? Portable alpha is only possible if it really was alpha and can be isolated. Attempting a separation of beta and alpha diverts attention from what investors really need - consistent absolute returns from a blended range of truly uncorrelated strategies. A DIFFERENT return source stands by itself either as a performance enhancer or risk reducer. What is the need for "portable"?

The portable alpha mania originates from traditional 60/40 stock and bond asset allocation. Haven't we all evolved beyond that by now towards multiasset and multistrategy? Shouldn't investors be moving to a 5/5/5/5...5 split among traditional assets, alternative asset and strategy classes? An investor risking 60% in unhedged equity and 40% in unhedged fixed-income is NOT diversified. And if futures and total return swaps are acceptable beta vehicles in implementing these wonderful things called portable alpha and beta overlay, why bother with "passive" managers?

If an investor owns thousands of global stocks and bonds managed by passive and active traditional funds, they might think they have spread their risks sufficiently but they have not. Such a portfolio is concentrated in only two asset classes - equity and fixed-income - and just one strategy class - unhedged long only. Such lack of portfolio diversification is simply too risky. Equity and credit correlations continue to rise in this current bull market and will get even higher in a bear market so historical notions of "diverse" asset allocation are not enough.

The initial efforts at asset class diversification into private equity and real estate did not do much to reduce strategy concentration. Long only equity is still long only equity regardless of whether it is public or private while real estate is dependent on a growing economy and benign credit markets and borrowing rates. Those "alternative" investments weren't really very alternative at all. Both derive from the traditional strategy of purchasing an asset, with no risk management or hedging, but often with leverage. Such assets, with their intermittent valuation and illiquidity disguise significant cointegration and dependence on the health of the public stock and bond markets.

Hedge funds are strategy classes NOT asset classes. For a properly diversified portfolio, investors need numerous sources of INDEPENDENT returns. They require strategy and asset class diversification to complement traditional securities. For example, with commodities and currencies, there is not really an "asset-like" return, therefore trading skills are required rather than established "investment" expertise.

Hedge funds generate returns from widely varied strategies and holding periods including, but not limited to, relative value, short selling, spread trading within and between securities and their derivatives, monetizing second order market phenomena through statistical and volatility arbitrage and new proprietary strategies. Similarly new asset classes, often requiring specialist domain expertise, include energy, distressed assets, CDOs, collateralised high yield loans, weather derivatives, movie financing, reinsurance, carbon emissions, fine art and even footballers and other potential return streams yet to be tradeable or investable. All this strategy and asset innovation REDUCES risks, exposures and portfolio dependence on the usual bets of hoping equity indices go up and hoping bond issuers pay coupons and principal.

The current trendy topic is the separation of alpha and beta. This assumes such a performance attribution split is necessary in evaluating and allocating to strategy classes, also known as hedge funds">hedge funds. Even the most "market neutral" hedge fund is dependent on some underlying, possibly changing, market factors. This hyperbolic focus on "Was it alpha or beta?" misses the point. What actually matters is getting a blended portfolio return of 10% or so at the lowest volatility, under ANY economic scenario EVERY year. It may be counterintuitive to some but the MORE different risks you take, the LESS the overall risk in the entire portfolio,?provided the exposures are independent.

So why portable alpha? Investors need to escape the mindset of benchmarking everything to stock and bonds. There is no need for a beta overlay; different return sources justify themselves. Obsession with outperformance of a traditional index, rather than absolute performance per se is what caused problems in the first place. If beta is doing well, who cares about alpha? In contrast, if market or strategy beta fares poorly, "outperformance" is unlikely to save the situation, because negative beta usually swamps any positive alpha. What really matters is having lots of completely different, performance generators with numerous strategies across many asset classes. There is no need to "port" these strategy returns onto traditional assets. Even strategies that haven't done well on a stand alone basis, like short biased hedge funds">hedge funds, can add value by smoothing volatility, lessening risk and factor dependencies.

Owning stocks and bonds might be necessary but is NEVER sufficient. And portable alpha isn't the answer, it is having sources of independent returns from as many DIFFERENT strategy and asset classes as possible. The safest option is to have many fund managers doing different things, in different ways, in different assets with holding periods ranging from seconds to decades. That is TRUE diversification.

by Veryan Allen. Copyright

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