ALPHA TRANSPORT: AN INNOVATIVE APPROACH FOR INSTITUTIONAL INVESTMENT MANAGEMENT
BY RALPH FRANK
(MERCER INVESTMENT CONSULTING)
Portfolio total return is generated by two different sources: the return generated by the investment market and the skill of the investment manager. These two components may be represented separately when decomposing return:
• The portion arising from the market is known in the industry as beta or benchmark risk. It is termed "systematic risk" as it is the inherent risk of being invested in the market.
• The balance of the return arises from the investment manager's skill and is called alpha. This is the portion of return generated by the investment manager deviating from the benchmark at his or her discretion and thus is considered to be non-systematic as they have control of these decisions. Generation of alpha is therefore generally associated with active investment management.
Historically, alpha and beta have been intertwined in portfolio construction because aggregate investment structures have been focused on strategic asset allocation considerations. These have included certain overall performance targets for the aggregate portfolios, as well as specific targets set for each underlying asset class.
Under this traditional approach, portfolio managers look at the aggregated total outcome from alpha and beta within each asset class. This structure therefore often limited the portfolio manager's potential to generate alpha if the market selected through the asset allocation process was relatively efficient (i.e., presented limited opportunity to generate alpha).
However, portfolio management techniques have evolved sufficiently such that it is now possible to reliably separate alpha and beta and attempt to capture them independently of one another. In doing so, the aggregate investment structure can now target the combination of alpha and beta that represents the desired risk and return trade off. In turn, this means the aggregate investment structure is also efficient in attaining its specified objectives.
The Alpha Transport Process
This process of marrying the optimal combination of manager skill (i.e. alpha) together with the desired strategic asset allocation (i.e. beta) is referred to as "alpha transport." Alpha may be captured from any asset class where it is available (and where the manager has sufficient skill to outperform the chosen benchmark). It may then be "transported" back to the base asset class by using derivatives, generally futures and/or swaps, which serve to overlay the alpha generated onto the base asset class beta.
There are two ways of generating alpha: explicitly or implicitly:
* An explicit strategy refers to an "absolute return" strategy where the alpha generated is separated from the beta of the underlying investments (e.g. market-neutral hedge funds). These strategies are relatively simple to use in an Alpha Transport-based structure.
* An implicit strategy is one where the alpha and beta have not been separated (e.g. long only equity funds). The aggregate return the investor receives is a combination of the two factors. In order to integrate an implicit strategy into an Alpha Transport program, the beta characteristics of the portfolio have to be stripped out. This can be done, assuming a relevant index can be identified and derivatives can be written on this index, using futures and/or swaps.
Practical Considerations in Applying Alpha Transport
There are a number of risks and practical considerations relating to the Alpha Transport process. These need to be considered and understood by institutional investors before applying the approach.
Some of the main risks include the availability of appropriate markets, the risks associated with using derivatives, lack of liquidity, capacity constraints, and cost management. Furthermore, the implementation arrangements, fee implications and regulatory issues surrounding this approach all need to be considered on a case-by-case basis.
Alpha Transport, while not applicable universally, may be a viable option for investment of parts of some funds. In particular, it is only viable where efficient transport mechanisms exist in the market.
We believe that many markets are now in the position to reliably provide opportunities for institutional investors (e.g. pension funds, insurance companies, etc.) to use alpha transport successfully. The application of an Alpha Transport strategy to the right portfolio will allow the efficient and effective allocation of the overall risk budget.
Ralph Frank is a Senior Consultant at Mercer Investment Consulting in the United Kingdom. Telephone: +44-20-7963-3344.
