Figure 1: Portable Alpha

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1 This publication is intended for intermediary use The finance industry is always evolving as new money management studies to come to the fore. Hedge funds have certainly been at the front end of this evolution due to their ability to utilise modern finance tools. One of newest evolutions to hit the asset management industry is the ability to efficiently implement an alpha/beta asset allocation strategy through portable alpha. Although portable alpha strategies have been in existence offshore since the 1980s in one form or another, they have only recently gathered momentum in the local asset management industry. The objective of a portable alpha strategy is to separate skills-based return (alpha) from market return (beta), then adding the index as an overlay to improve the risk return profile. Figure 1: Portable Alpha How the asset management industry has evolved Before the advent of Modern Portfolio Theory by Harry Markowitz, asset management was seen as more of an art than a science. Markowitz demonstrated that you could maximise your reward for a level of risk. Sharpe s Capital Asset Pricing Model (CAPM) took this a little further by introducing the notion of a market return. It took close to 20 years before the asset management industry started applying this widely-accepted concept in academia into practice. In 1971 William Fouse and John McQuown of Wells Fargo Bank established the first index fund, which tried to replicate the market return, a concept that John Bogle would use as a foundation on which to build The Vanguard Group, a mutual fund powerhouse renowned for low-cost index funds. Then in the 1990s the concept of Active Management began to gain foothold, with the notion that you could outperform the index benchmark by making certain investment decisions or using certain strategies. Active managers generally underperformed their benchmarks, which led to questions being raised about the role of active management, with its added cost to asset management.

2 The phenomenal performance of the Harvard and Yale endowments using their Core-Satellite approach proved that there was a place for both index funds (core) and active funds (satellite) but there had to be a distinction between the two. Investors also had to choose the right vehicles to access beta and the right investments to access alpha. The problem was that it was difficult to apply this approach in practice. Figure 2 Traditional Investment Framework Traditional investment has historically consisted of an investment committee or a financial adviser setting strategic allocations to asset classes and then choosing index funds and active managers which best meet their liability stream whilst at the same time maximising their possible return. The strategic allocation benchmark becomes the yardstick against which the investor is measured. The investor s asset allocation objectives are to minimise the probability of underperforming the liability stream, whilst at the same time maximising the possible return, given the uncertain nature of long-term investing and uncertain longterm investment expectations.

3 CUMULATIVE PERFORMANCES Figure 3: Traditional Investing in Equity Managers on the JSE Top Quartile Manager ALSI From the graph above, more than half of all active managers underperformed the ALSI over the period under observation. Therefore a number of institutional and high net worth investors investing in these active managers would have underperformed their strategic benchmarks. To outperform the ALSI index the equity manager should have been top quartile. But how many of us can consistently pick top quartile managers over the longer term? The answer is you don t have to, and this is why. The ABC of Portable Alpha Portable alpha is the application of financial engineering to improve a portfolio s risk-adjusted return by adding a diversified source of alpha while maintaining the total portfolio s market exposure (beta). The beauty about this strategy is that instead of looking for alpha and beta within the same investment, the two decisions are separated so as not to muddy the waters. Beta can be cheaply overlaid onto the alpha source by using derivatives or swaps. Alpha is not so easily extracted but once found it can be transported to virtually any asset class. Figure 4

4 The mechanics of Portable Alpha To implement a portable alpha strategy you require a beta engine and an alpha engine. The beta engine will involve buying derivatives or swaps on an index. The alpha engine is required to meet a set of conditions. The alpha source has to be consistent, significant, diversified and beta agnostic. Figure 5 The portable alpha manager can replicate the return on an index by purchasing short-term bills and and futures on the Top40 index. However full collateralisation of the ALSI Top40 futures index is not required and the manager only deposits a margin into the margin account. The margin is only a fraction of the full exposure to the index and the remaining cash is used to invest into the alpha engine. If the alpha engine performs better than the risk-free rate, then this excess return (alpha) is ported onto the ALSI Top40 index. Funds of Hedge Funds as a source of alpha Hedge funds by their nature are skills-based investments designed to extract alpha regardless of what happens to the market. Figure 6 shows the excess return (alpha), the standard deviation and return per unit of risk generated by top quartile South African equity funds, bond funds and the Blue Ink Hedge Fund Composite which is an equally weighted index of all South African hedge funds. Hedge funds have extracted more alpha than bond and equity managers; therefore their alpha generation is significant. They have done that over a 10 year period at a lower standard deviation (consistent). By investing in a fund of hedge funds, which combines a number of different hedge funds, an investor can create a diversified hedge fund portfolio.

5 Figure 6 Excess Return (Alpha) Standard Deviation (Tracking Error) Return per Risk (Information Ratio) 1.80% 10.00% % 1.40% 9.00% 8.00% % 1.00% 0.80% 0.60% 7.00% 6.00% 5.00% 4.00% 3.00% % 0.20% 2.00% 1.00% % Top Quartile Equity Alpha Top Quartile Bond Alpha Hedge Fund Composite 0.00% Top Quartile Equity Alpha Top Quartile Bond Alpha Hedge Fund Composite - Top Quartile Equity Alpha Top Quartile Bond Alpha Hedge Fund Composite Furthermore hedge funds are beta agnostic with the Hedge Fund Composite only having a beta of 0.08 to the ALSI and 0.09 to the ALBI. Figure 7 Beta ALSI ALBI Hedge Fund Composite Figure 8 By utilising a portable alpha approach an investor can easily outperform the index. In the graph above, we utilised the Blue Ink Hedge Fund Composite as the alpha source and the ALSI Top40 index as the beta proxy. The portable alpha

6 approach is therefore an easier way to outperform, without paying exorbitant fees to asset managers, who may or may not outperform. Conclusion Blue Ink runs a number of portable alpha funds and we believe this is an efficient way for institutional and retail investors to enhance returns. References AIMA Transport Strategy Paper, AIMA Canada Whitelaw F., Bruno S., Davidow A., Alpha/Beta Separation: Getting what you pay for, Portable alpha: A Practitioner s Guide, Morgan Stanley Alternative Partners, Glacier Research would like to thank Tatenda Chapinduka for his contribution to this week s Funds on Friday. Qualifications: BBusSc Actuarial Science (Quantitative Finance), Chartered Alternative Investments Analyst (CAIA). Tatenda joined Blue Ink in 2010 as a Research analyst; he is currently a Portfolio Management and a member of the Investment Committee. His four year experience in the industry includes portfolio construction, risk management, managing research and selection, quantitative analysis and financial markets research.