financial weapons of mass destruction or portable alpha panacea imn plan sponsor and consultant...

Financial Weapons of Mass Destruction or Portable Alpha Panacea

IMN Plan Sponsor and Consultant CircleSan Francisco

David LermanOctober 23, 2007


Portable Alpha: Why the Fuss?

•Google has how many entries on Portable Alpha?

•Surging popularity…every institutional equity based conference has at least one slot on portable alpha (aka, enhanced indexing, alpha -beta separation)

•Amount of assets a testimony to its elegance/efficacy

But why?

•Returns achieved by investors have been challenging

•Sub 4.5 % long rates don’t help. Neither does Sub-prime mess

•Failure of most long only active managers to consistently beat their benchmark

What’s an institutional investor to do?


Portable Alpha: What is it?

Simply put, portable alpha is a strategy whereby an investor mounts or ports an uncorrelated alpha asset generator on top of an indexed portfolio.


Portable Alpha: What does it look like?

Then

Traditionally, a long only equity manager are restricted in their search for excess returns. Large caps manager can’t drift beyond large caps and typically have to settle for “tilting” names like MSFT, JNJ and GE. They can’t short and they can’t do emerging markets or hedge funds.

Now

A manager can gain long, large cap exposure via S&P 500 futures (beta) and mount or “port” on top of this alpha from a separate source such as fixed-income, hedge funds, long/short strategies…etc


Portable Alpha: What does it look like? cont.

Illustration:

Institutional investor…Buys $100 million notional exposure through S&P 500 futures

Each futures has notional value of 1,530 x $250 = $382,500.

Position would require 261 futures contracts. [$100mm/$382,500 = 261]

But, futures collateral is only a fraction of notional amount

Collateral (aka Performance bond margin) for 261 futures contracts = 261 contracts x $19,688/contract = $5,138,568

So what do you do with the other $94.86 million?


Portable Alpha: What does it look like? cont.

As with many things in the U.S., like call centers, payroll, aircraft engine repairs (that’s not a misprint) The $94 million is essentially “outsourced”.

Where will you search for excess returns? The universe of asset classes is large.

What is your particular area of expertise?

What are the pros and cons?

Which derivatives will be utilized for the beta component?


Portable Alpha: Assembling the components

Where will you search for excess returns?

“Alphas are most frequently ported across asset classes, from quantitative equity or macro strategies or from hedge fund portfolios.” *

Beta + Alpha

S&P 500 Futures short duration fixed income portfolio

S&P 500 Swap hedge funds or fund of funds

S&P 500 Futures long/short strategy (e.g. active long small cap with short Russell 2000

futures overlay)

* Source: Goldman Sachs


Portable Alpha: Newer tools…

What’s new in portable alpha?

With the advent of futures on MSCI EAFE, plan sponsors, & money managers—with about $1.6 trillion benchmarked to EAFE—are beginning to port alpha onto EAFE futures contracts as liquidity grows

And just a few days ago, futures became available on MSCI’s Emerging Markets Index.

So the tools continue to grow…


Pros and Cons concerning the “beta” source

Futures

Pros Cons

Incredibly liquid roll costs

Incredibly cheap collateral consider.

Highly transparent T.E. depending on product

used*

Virtually no counterparty risk

*For actively traded index futures contracts, Tracking error is insignificant—especially with adventof month end fair value calculation

OTC Swap Market

Pros Cons

No roll cost Counterparty issues

No T.E little transparency

Costlier than futures


Sampling of Global Stock Index Beta LiquidityAverage Daily USD Volume Month of August 2007

0

20

40

60

80

100

120

140

160

180

200

S&P 500(CME)

EuroSTOXX(Eurex)

DAX futures(Eurex)

All 1440 ETFsGlobally

Nasdaq 100(CME)

Dow Jones(CME)

Russell 1000(ICE)

Ave

rag

e $

vol/d

ay in

bill

ion

s

Source: Goldman Sachs, CME Research


Sampling of Global Stock Index Beta LiquidityAugust 2007 Month End Open Interest in USD

0

50

100

150

200

250

300

350

400

S&P 500(CME)

EuroSTOXX(Eurex)

DAX futures(Eurex)

Nasdaq 100(CME)

Dow Jones(CME)

Russell 1000(ICE)

Op

en in

tere

st in

bill

ion

s

Source: Goldman Sachs, CME Research


Cost of Initiating futures (Beta) position


Cost of Initiating futures (Beta) position

Some stock index futures as well as other futures products have incredible liquidity.

S&P 500 futures (reg & mini)

Russell 2000 (reg & mini)

Nikkei 225 (USD/Yen)

EuroSTOXX

U.S. 10-yr Note futures


Cost of Maintaining futures (Beta) Position

Just as important as the low cost and liquidity is the cost of maintaining the position. To maintain exposure, managers need to “roll” their positions to the next expiration.

Calendar Roll date S&P 500 Russell 2000

Sep 04 / Dec 04 9.10 -74.38

Dec 04 / Mar 05 10.59 -22.41

Mar 05 / Jun 05 3.04 -65.83

Jun 05 / Sep 05 2.90 -96.90

Sep 05 / Dec 06 -1.87 -64.19

Dec 06 / Mar 06 3.98 -98.81

Mar 06 / Jun 06 -3.22 -101.84

Jun 06 / Sep 06 -4.37 -70.77

Sep 06 / Dec 06 0.91 -77.51

Dec 06 / Mar 07 3.91 -63.62

Mar 07 / Jun 07 -2.75 -81.35

Jun 07 / Sep 07 -10.17 -96.06

Average 0.85 -76.14

Source: Richard Co, CME Research


Portable Alpha: Additional Considerations

While the basic tenant of portable alpha is simple, implementing the strategy is more complex. You have:

Risk management, monitoring, reporting and cash flows

…the beta portfolio

…the collateral issues for beta portfolio (margin calls)

…the ported alpha portfolio

Investor can assume responsibility for some or all of above or hire a provider to do some or all of above (i.e., unbundled, semibundled, integrated)


Portable Alpha: Summary

►Portable alpha allows for diverse investment opportunities by allowing investors to choose

from a broad class of assets with a large mix of risk/return characteristics.

►Portable alpha doesn’t always mean lower risk…but diversification stated above can lower a

risk profile.

► Beta vehicles, such as the S&P 500 futures are among the most liquid futures contracts in

the world. They come with excellent transparency. For certain beta choices that do not have

liquid futures, the swap market is a good alternative

► Particular expertise is required in all of the choice of alpha generators—be it fixed income,

hedge funds or other strategies

► Insufficient positive excess returns from the alpha source and excessive costs will doom

portable alpha strategies.


Quote of the day…

“I make presentations to pension plans with a half dozen active managers in style and market cap boxes. If these funds separated their alpha and beta, they would find risk and returns are nearly all beta. All they have is an expensive index fund”

Tim Harbert (Former CEO of State Street Global Advisors)

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