It 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.

With many investors now convinced that markets will trade sideways for some time, they say beta returns should be forsaken in favour of alpha-centric returns.  Meanwhile, emboldened by what they see as a fire sale in equities, many other are increasing their equity beta exposure right now.  As a result, the age-old tug-o-war between active and passive management seems to have moved back to the front pages.

S&P released this report earlier in the week that was aimed squarely at those who believe active management embeds some kind of put option that protects it during market downturns.  The report highlights the common assumption that active managers can move to cash in times of distress – that they essentially trim their beta exposure in response to the prevailing winds (an argument often made by hedge funds – the quintessential active managers).

But despite this apparent advantage, S&P found that less than half of active managers outperformed their benchmarks in 2008 – a period when markets fell precipitously.  The report doesn’t mince words:

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Dennis Tito

Founder, Chief Executive Officer and Chairman of the Board of Directors, Wilshire Associates.

Wilshire Associates
Bio (Wikipedia)
Relevant Postings (AllAboutAlpha.com)

With so much interest in commodities, we thought this might be a good time to revisit the rationale for so-called managed futures funds. But as Keith Black, CAIA, of consultant Ennis Knupp + Associates says, commodity investing is about a lot more than buying and holding commodities in hopes that the Chinese continue to buy new cars.

The Case for Commodities

Special to AllAboutAlpha.com by: Keith Black, CFA, CAIA, Associate, Ennis Knupp + Associates

Over the last several years, institutional investors have more than doubled their allocation (to over $200 billion), to financial products whose returns are linked to those of commodity indices. Commodities may be attractive due to: the low correlation between their returns and those of other asset classes, the high correlation of commodities returns with unexpected inflation, and the rising demand for commodities from fast-growing emerging markets countries, such as China and India.

In fact, when you look at the performance of these commodity indices during the best and worst quarters for the Wilshire 5000 (and quintiles in between), you can see that they have produced modestly positive returns in almost all quintiles. In fact, the correlation between commodity indices and other major asset classes is generally below 0.2.

Commodity Beta via Equities

While these indices provide a simple method of gaining commodity exposure, one could always implement their views on commodity prices by investing in equity securities. The prices of these stocks may be somewhat correlated with those of commodity futures. Metals firms include Alcoa and Anglo American, while agricultural firms include Archer Daniels Midland. In the energy sector, stocks such as Exxon-Mobil, Chevron and ConocoPhillips may be used as a crude oil proxy.

But the problem is that existing exposure to equities means commodity-linked equities may not be the best way to express a view on commodity prices alone. To make matters worse, commodity stocks are likely to underperform commodity futures during times of high inflation. When inflation and commodity prices rise, stock prices typically decline, meaning an investor may not actually earn the anticipated return.

The bottom line is that commodity futures are a more direct way to earn the diversifying benefits of commodity investments (especially metals, energy and agricultural commodities) without increasing the stock market risk of the overall portfolio.

Sources of Return

Part of the reason for this is that the total return to a commodity futures index consists of three components: spot return, roll return and yield. The spot return is the return to an investment in physical commodities. The roll return is earned in the process of passively trading (rolling) futures contracts as they mature and must be replaced. The yield is the interest earned on a short-term fixed income investment that is pledged to the futures exchange in order to maintain the collateral required to back the futures investments. As you can see from the table below, the annualized return of the S&P GSCI can be attributed to each of these three components.

But commodity price increases have not exceeded the rate of inflation over long periods of time. As new natural resources are discovered, production technologies improve and research advances in areas such as crop engineering and alternative energy, commodity prices tend to decline in real (after-inflation) terms. So how could commodities futures have offered a total return rivalling that of equities since 1970 if the ownership of physical commodities does not offer a return that exceeds inflation? The answer is in the roll return and the collateral yield, as shown in the chart below.

The roll return and collateral yield can only be earned when investing in commodity futures. The return to commodity futures investments has significantly exceeded that of a direct (spot) investment in commodities over the last 37 years. This is because futures contracts have a finite life. Commodity index investors normally invest in the contract nearest to expiration, which is typically less than three months. In order to maintain a consistent exposure to a given commodity, the investor must purchase a new contract at or before the time of expiration of the current contract. The roll return to a commodity futures investment is earned when the futures position is rolled from the current contract to a later-dated contract.

When a futures curve is in backwardation the investor buys a contract at a lower price, say $70 for the June contract, and sells it at a higher price of $75 when prices rise as the contract nears expiration. Should the curve retain the same shape, with the front month futures trading at a premium to later-dated contracts, the investor will earn a positive roll return as time passes and the June contract becomes the premium-priced front month contract.

Conversely, an upward-sloping futures curve is one in which later-dated contracts trade at a higher price than the current futures contract (contango). Contango markets are undesirable for a commodity futures investor as the return to rolling futures contracts is negative.

The secret behind commodity futures: roll return

Futures markets are likely to remain in backwardation when producers of a commodity desire to hedge the sales price of their commodity production. A positive roll return can be earned when producers view futures markets as insurance and are willing to sell futures at a low price in order to insure against a decline in the commodity price.

The market will continue to offer a positive roll return as long as the demand for producers to sell is larger than the demand from investors or speculators to purchase those contracts. However, over the last two years, investors have funnelled over $50 billion into indexed futures investments and a number of exchange traded funds (ETFs) were launched that invest in oil, gold and silver futures.

The result of this additional demand for investments in commodity futures has served to move many futures markets into contango. The potential to experience a negative roll yield during certain market conditions is one reason why EnnisKnupp does not recommend passive investment in products that track commodity futures indices for most clients. Another reason is that over time, commodity investments have been quite volatile and the returns don’t fit well into a traditional asset valuation framework, such as the Capital Asset Pricing Model (CAPM). Variables such as political strife and weather can have a significant impact on both long-run and short-run commodity prices.

Actively Managed Commodities Funds

Given the drawbacks of commodity-linked equities and commodity futures indices, where does this leave us? It turns out that active management of roll dates and index selection can add significant value in commodity futures markets. For example, in a case where the entire futures curve for a given commodity is in contango, an active manager can choose to reduce or eliminate exposure to that commodity.

In addition, managed futures funds (CTAs) allocate about 25 percent of their assets to commodity markets and 75 percent of their assets to financial markets, including currencies and futures on equity indices, interest rates and bond prices.

Flexibility and the addition of non-commodity futures results in a relatively low correlation between managed futures and (passive) futures indices. Global macro hedge funds, which often trade commodity futures also have a low correlation to futures indices as the table below shows.

Conclusion

Commodity investing is about a lot more than simply hoping commodities will rise over time. After all, the GSCI spot index earned an annual return of only 4.0 percent since 1970, cash returned 5.8 percent and CPI increased by 4.6 percent per year over the same time period. But with so many factors influencing price movements (roll, demand/supply etc.), active commodity management can provide real alpha opportunities.

Ennis Knupp + Associates does not recommend strategic allocations to commodity futures investments. However, we do believe that commodities have a role in the portfolio of plans that value the historic tendency of commodity futures investments to have a higher correlation to inflation and a lower correlation to traditional stock and bond investments.

- Keith Black, June, 2008

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.

Editor’s Note: Keith is the author of a more detailed paper on commodities and timberland in institutional portfolios available here at Ennis Knupp + Associates’ website.

When Credit Suisse and S&P both recently announced 130/30 “indices”, we struck a note of skepticism.  Wasn’t such an active index an oxymoron?  Doesn’t a short-extension simply leverage a manager’s pre-existing alpha?  And if so, isn’t such an index just an arbitrary benchmark based upon the underlying alpha-generation model?

Andrew Lo provided some arguments in favour of such an index in his December 2007 paper “130/30: The New Long-Only“.  In it, he acknowledges:

“our proposal to put forward an algorithm or dynamic portfolio as an index is a significant departure from the norm. Existing indexes such as the S&P 500 are defined as baskets of securities that change only occasionally, not dynamic trading strategies requiring monthly rebalancing.  Indeed, the very idea of monthly rebalancing seems at odds with the passive buy-and-hold ethos of indexation.”

According to a paper published in the January 2008 edition of the Journal European Financial Management, the “passive buy and hold ethos of indexation” ain’t so passive after all.  The paper (earlier version available here), finds that most indices are chalked full of active biases – making a truly passive index a rare animal indeed.  This, of course, is the central argument made by proponents of fundamental indexation (see related posting, “Arnott: Does My Beta Produce Alpha?”)

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Short-extension strategies now have an extension of their own – into the world of fixed income investing.  In a paper that sounds reminiscent of this one on fixed income 130/30 by Prudential and this webcast on fixed income portable alpha by Morgan Stanley (AAA dossier sign-in required), Baring Asset Management reiterates that 130/30 isn’t just for the equity crowds anymore.  After a dearth of news on fixed income 130/30 since the spring, we’re glad to see it back in the daylight again.

According to HedgeWeek, Toby Nangle, Barings’ director of fixed income management says:

“Most of the debate around 130-30 strategies has, up to now, been focused on the equity side. However, the sources of excess returns and the potential benefits in 130-30 fixed-income investing are quite different from the equivalent equity only mandates.”

Although the markets are different, the primary rationale behind fixed income 1X0/X0 is the same as it is for equities: to enable over-sized negative bets in smaller markets (what the report calls “inter-market spread positioning”).  Other sources of fixed income alpha mentioned in the report include:

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With 1X0/X0 strategies pegged to draw in trillions over the next decade, the sticky question of the potential market impact was top of mind today in New York at a conference focused on portable alpha and 130/30 strategies.  Participants ruminated on portable alpha yesterday.  Today was all 130/30.

With the short selling required for 130/30, the 800 pound gorilla in the room was the finite supply of stock actually available to borrow.  In a posting last fall, we discussed a report by Goldman Sachs on this topic (see related posting).  Speakers here seem to share our skepticism about whether this posed an immediate problem.

However, many weren’t so sanguine about the longer term.  I asked Deutsche Bank’s Brian Bausano, Co-head of Global Prime Finance for the firm, whether there would someday be a “shortage of shorts”.  He replied that, notwithstanding today’s huge excess borrow capacity, potential shortages would be “non-linear” and would likely occur in certain parts of the market first.  For example, he suggested that borrow shortages would likely show up in small-cap names first since small cap names are more likely to be shorted by 130/30 managers and since there is simply less stock available in these names.

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There is obviously something in the water in California that has led to uncommonly large cerebral cortexes in some of its citizens.  This is partly evidenced by the flood of financial innovation coming from the Left Coast for over a generation – from Barr Rosenberg to Bill Sharpe, BGI/Wells Fargo, Analytic, and Wilshire.   Even Harry Markowitz loved the place so much, he recently conducted a presentation in Boston by satellite so he wouldn’t have to leave (see posting).

Today, we are pleased to bring you a guest posting from one of the homes of the large-brained Financialus Californius: Jia Ye of First Quadrant L.P.  In this summary of a yet-to be-published First Quadrant white paper, Ye warns us that not all managers can benefit from removing the so-called short constraint.  And what she has found may surprise you.

Do Short Extensions Benefit All Managers?

By Jia Ye, Director & Chief Investment Strategist, First Quadrant L.P., Special to AllAboutAlpha.com

Contrary to popular belief, the ability to take short positions in equity portfolios does not necessarily lead to superior performance for all managers.  When we take into account the positive skew in stocks returns, only managers who can maintain a stable correlation between forecast and realized returns (captured by the manager’s information coefficient or IC) can take full advantage of the efficiency gains from short extensions. In other words, the ability to short stocks will not necessarily help managers with an unstable IC.

As the volume of articles here at AllAboutAlpha.com clearly illustrates, there has been a lot written recently about short extension (1X0/X0) strategies.  But there is little mention, here and elsewhere, that studies of this topic are based on one or both of the following implicit assumptions:

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Continuing the proud tradition of the “Rumble in the Jungle” and the “Thrilla in Manila“, Financial Planning Magazine hosted what it called the “Fundamental Indexation Smack Down” last month between the inventor of fundamental indexation Rob Arnott (the Patent King of Pasadena) and Gus Sauter, CIO at Vanguard.  The entire 15 rounds was just released in a 60-minute webcast – and there’s no annoying $30 pay-per-view charge. (see entire video here, audio here)

It’s actually a pretty interesting 60 minutes.  (Thankfully, even more exciting than the 60 minute SEC meeting we watched earlier this week.)  However, if you’re pressed for time, you will find that both Arnott and Sauter make their key arguments in the first 25 minutes (but you will miss Arnott’s taunt in Round 7 when he pointedly asked Sauter, “Why are you so scared of this?” – not quite Jack Nicholson’s “You can’t handle the truth!”, but a high point nonetheless).  Whether you make it to the end or not, you will find it’s a great way to get up to speed on the arguments for and against fundamental indexation without having to reading mind-numbing academic papers.

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Location: New York
Dates: November 7-9, 2007
Organized By: Terrapinn

In a great example of real-time market response, organizers of “Portable Alpha USA” have recently added “130/30″ to the mix. While these two topics might appear to be slightly different species, we argue that they are part of the same genus: alpha-centrus investingae. Portable Alpha advocates would have investors lever their beta (keeping it at the same level) and use the capital to allocate to an alpha source. Similarly, 130/30 also involves alpha/beta separation, but keeps the beta 100% funded and effectively allocates to an “unfunded” market neutral alpha source (well, at least not truly “unfunded” since the beta source essentially acts as collateral for taking on the short positions).

Some of our favorites will be there: Harvard’s Randy Cohen (related posting), Prudential’s Michael Lillard (related posting), Man Investment’s Angelo Calvello (related posting), Casey Quirk’s Jeb Dogget (related posting) and Wilshire’s Jim Dunn (related posting).

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By: John Ilkiw, SVP Portfolio Design & Risk Management, Canada Pension Plan Investment Board
Published: Winter 2006 Canadian Investment Review

Yes, you read the title of this article right.  It was Michael Jensen, not William Sharpe, whom actually used the terms “alpha” and “beta” for the first time in 1967’s now famous paper with the catchy title, ”The Performance of Mutual Funds in the Period 1945-1964“.  According John Ilkiw of the US$90 billion Canadian Pension Plan, Sharpe actually used the terms ”A” and “B” instead of “alpha” and “beta”.  Thank goodness for Michael Jensen, since if it weren’t for him, you would be reading AllAboutA.com right now.

But Ilkiw’s historical findings don’t end there.  He reports that one of the first people to make serious money off the more-marketing-friendly term “beta” was Dennis Tito who in 1970 published a “beta book” for an LA brokerage firm and soon after founded Wilshire Associates to package and sell beta.  Thirty years later (in 2001) Tito became the first-ever civilian to visit the International Space Station (yes, that Dennis Tito), proving that in the long-run Beta will go to the moon – or at least part way.

Read Full Article

Earlier today (Monday), I spoke with Jim Dunn, VP at Wilshire Associates about the firm’s new partnership with hedge fund manager Fairfield Greenwich Group to provide a turn-key portable alpha solution.

A former convertible arbitrage manager and graduate of Villanova University, Dunn was hired by Santa Monica-based Wilshire about 18 months ago to spearhead the firm’s move into hedge fund-related strategies. He says that Wilshire’s view of hedge funds has undergone a metamorphosis over the past two years as the firm looks for ways to marry passive and active management.

The new offering is based on Fairfield’s existing fund of funds program. He describes Wilshire’s value-add as a) selection of appropriate betas b) counter-party relationship management and c) fiduciary activities.

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By: Allan Sloan, Newsweek
Published: October 30 Issue

Newsweek’s Allan Sloan, “The Cruncher”, offers up some pretty weak evidence this week that a bubble exists in hedge funds:

“Day after day, I hear about hedge funds’ growing power—we’re up to almost 9,000 funds with $1.225 trillion in assets, according to Hedge Fund Research, from about 3,600 with $456 billion at the start of 2000. To you, this may mean they’ll grow forever. To me, it feels like something bad’s about to happen.”

Firstly, as we have discussed on this blog, the industry became quite concentrated between 2000 and 2006 (as the mutual fund industry did years earlier).  As several respected institutional investors have told us recently, there are really only about 700-1,000 funds that would make it onto an institution’s investment radar screen (not 9,000).  And according to research by Alpha Magazine, large segments of the industry actually shrank between 2004 to 2005.

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