How to Generate Alpha in a Predominantly Beta World - New York...
http://www.nytimes.com/2005/11/30/business/30place.html?pagewa...
November 30, 2005
Market Place
How to Generate Alpha in a Predominantly Beta World
By RIVA D. ATLAS
Money managers have been stepping up their search for Wall Street's holy grail: an investment that consistently generates "alpha."
While that may just be Greek to people far removed from Wall Street, when money managers talk about alpha, they are referring to investments that make money even
when markets are slumping. It is the opposite of beta, the term applied to investments whose returns tend to track the market.
With conventional beta investments in stocks and bonds earning low single digits, a growing list of money managers are pitching an alternative, known as portable
alpha. This fancy sounding name refers to a relatively simple strategy: combining an ordinary stock or bond index with something that the investor believes will
provide alpha.
If the source of alpha outperforms the stock or bond index, investors in portable alpha strategies, which include large pension plans, figure they are ahead of the game.
Here's how it works: An investor with, say, $100 million to invest puts down a fraction - 5 percent or less - to enter into a derivatives contract with a notional value of
$100 million linked to the performance of the Standard & Poor's 500 or some other benchmark index. The investor stands to gain - or lose - the difference between the
index's performance and the cost of the contract.
That's the beta component. The remaining $95 million is put into something else that the investor believes will generate a different return, not tied at all to that index.
Increasingly, that money is being invested in funds of hedge funds. The $95 million hedge fund investment represents the alpha; it is portable because its return is
being combined with that of the beta, or market-tied investment.
Sometimes a portion of the $95 million is kept in short-term investments to meet any margin calls on the derivatives contract in case the market drops sharply.
While hedge funds are a popular avenue, alpha can come from any sort of investment. Since 1986, for example, Pimco, the giant bond manager, has offered to combine
the beta of traditional stock indexes with the return of short-term bonds. The firm manages more than $30 billion in portable alpha strategies.
But as large investors get more comfortable investing in hedge funds, they are increasingly looking to these partnerships as their alpha provider of choice.
"Institutions are getting really aggressive about looking for alpha," said Jane Buchan, chief executive of Pacific Alternative Asset Management, which manages funds of
hedge funds. "They are investing anywhere they can find it."
Precise data on the size of the assets in portable alpha strategies are hard to come by, although Institutional Investor magazine recently estimated that some $125 billion
is invested this way by pension funds and other large institutions.
Even as all that cash is flowing into portable alpha strategies tied to hedge funds, some consultants fear such strategies will no longer outperform the markets to the
degree they once did.
"Portable alpha sounds great in theory, but I don't believe alpha is something that is just sitting on trees, waiting to be plucked," said Peter L. Bernstein, a consultant to
pension funds and other institutions. "Investors underestimate the risks in hedge funds."
Yet pension funds and other adopters of portable alpha strategies are increasingly getting their alpha from a diversified portfolio of hedge funds.
After the stock market collapse in 2000, hedge funds looked particularly appealing, returning 5 percent on average that year, according to Hedge Fund Research. But
hedge fund returns have started to falter even as tens of billions of dollars are flooding into their coffers.
Through Nov. 28, the CSFB/Tremont Investable Hedge Fund Index is up just 3.68 percent, compared with a 5.49 percent return for the Standard & Poor's 500-stock
index. That reverses a lead of more than one percentage point that hedge funds had over stocks through the end of October.
The recent performance is not expected to discourage the view that hedge funds can consistently generate alpha, given that there are few other attractive alternatives,
consultants said.
Robert Hunkeler, the director of International Paper's $6.9 billion pension plan, remains enthusiastic about his company's $340 million investment in portable alpha
strategies that include investments in funds of hedge funds.
International Paper began looking at the portable alpha concept after the market's steep drop in 2000, when the company was grasping for ways to invest its portfolio of
large-capitalization stocks.
International Paper was looking for a return of around three to four percentage points above the S.& P., Mr. Hunkeler said. Instead, it has earned just under two
percentage points above the index since it began allocating to portable alpha strategies in 2003.
"Returns haven't been as high as expected," Mr. Hunkeler said, but he attributed that to the relatively low volatility among stock prices this year. When stocks move up
or down it creates opportunity for investors to outperform by making aggressive positive or negative bets based on selecting particular stocks.
"Given the overall environment, we're reasonably satisfied with our performance," he said.
Managers of portable alpha portfolios agree that they are making the best of a poor market environment.
"This is a bet that pays off over long periods of time," Ms. Buchan of Pacific Alternative Asset Management said. "But that doesn't mean there aren't times when the
clock runs against you. There is no perfect solution."
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