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Minyan Mailbag: Portable Alpha




I have been reading about the concept of portable alpha and risk, and for the life of me I cannot crystalize in my mind how it works. Wall Street appears to be gearing up to sell this concept, especially if pension reform leads to asset/liability matching. This is supposed to be the solution to generating higher returns for the pension system above and beyond what a fixed income portfolio would produce. Of course, by defnition the alpha for all market participants is zero, so as a system it will do nothing other than create more fees for Wall Street.

Are you familiar with this strategy and if so would you be willing to provide Minyans with a brief explanation of how it works? I assume it is largely a derivative-driven strategy, so I wonder whether the whole system will just be adding incremental leverage in search for an aggregate alpha that by definition cannot exist and at the same time actually increase systemic risks? Thank you.

Minyan James


Please see this link for my previous comment on this.

The strategy you refer to is as you characterize it; unfortunately many pension funds have bought into this "product."

To have alpha, first you have to have a benchmark. Let's use in this case the S&P 500. The product being sold by Wall Street is simply this: put 98% of the desired notional amount in the S&P 500 and the remaining 2% in a fund of hedge funds through fund of funds (notice almost all large dealers like JP Morgan (JPM) have bought hedge funds themselves so they can share in the fees). The investment in the S&P 500 can be done through derivatives, like futures, that use leverage, thus allowing the pension fund to cheaply access the beta portion. The 2% exposure to hedge funds then is the "portable alpha" ported on top.

Supposedly this strategy "assures" the pension plan of outperforming the S&P 500 with actually lower volatility, thus the "portable alpha." The fund of hedge funds do have a high probability of having some return and some probability of having a high return. There is, of course, the probability that the fund of funds will actually lose money; that probability increases as the number of hedge funds and the money committed to them grows.

Of course this whole idea is ludicrous, though not obvious enough to discourage underwater (and desperate) pension fund managers from participating. The amazing thing is that Wall Street has been able to convince the pension manager that what is important is relative performance to an asset benchmark like the S&P 500; this is false. What is really important to the pension fund manager is relative performance to the fund's liabilities.

Beating the S&P 500, even being guaranteed of it (which they are not), does nothing for the pension fund manager when the S&P 500 underperforms the growth in the fund's liabilites.

Silly but sad.

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