Portable alpha strategies
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Portable alpha strategies

Explore how portable alpha strategies can potentially increase returns by separating the beta and alpha components of a portfolio.

Overview

Between today’s persistent low yield environment and lower expected asset class returns, investors need to find solutions to help increase overall portfolio performance and maintain a diversified asset allocation. Portable alpha strategies can help investors who seek both outcomes. By separating the alpha and beta components of traditional asset classes, portable alpha strategies help investors put their capital to its highest and best use.

Key points

01

Unlock portfolio capital

Portable alpha strategies, which separate alpha and beta components of traditional asset classes, can help investors increase overall portfolio performance and maintain a diversified asset allocation.

02

Fixing the alpha-beta mismatch

In equity portfolios, we believe that portable alpha can help redirect active risk budgets towards areas where alpha may be more abundant—unlocking capital in the largest part of investors’ portfolios.

03

Combating the low yield environment

In fixed income portfolios, we believe that portable alpha can seek higher absolute returns without compromising the role of bonds as equity diversifiers.

Defining portable alpha

The objective of a portable alpha strategy is to generate outperformance over a specific index. Portable alpha strategies consist of a target index exposure, or “beta” component, and a separate source of excess returns, or “alpha” component.

Portable alpha strategies effectively separate the returns of a target index (beta) and the returns of an alpha-seeking manager (alpha). This separation allows the returns of the alpha component to be “ported” on top of the investor’s desired market index exposure.

Mechanics of portable alpha strategies

There are three key steps to implement a portable alpha strategy. First, the investor chooses a target index for their beta exposure. Second, the target index is replicated using market-linked instruments. This part of the portfolio only requires a small amount of cash in the form of a margin requirement to achieve the exposure, but also comes with a cash financing cost. As a result, there is excess cash to allocate capital. The final step is to invest the remaining funds in an alpha source and a cash reserve.

Example implementation and expected return of a portable alpha strategy

Learn more about implementation and expected return of a portable alpha strategy.

Source: For illustrative purposes only. “Expected return” in the chart above assumes a 20% cash reserve and 20% cash margin that can be reinvested at the same rate as the cash financing cost to fund the market-linked instruments. The expected return is equal to the return of 100% market index plus 60% alpha source minus 60% cash financing rate. This is only an example of the potential of the investment strategy to be employed and does not take into consideration actual trading conditions and transaction costs. The figures are for illustrative purposes only and results cannot be guaranteed.

Thus, the return of the portable alpha framework is determined by how much capital is allocated to the alpha source, how much return it generates, the return of the index exposure, and the cost to finance the index exposure. It is important to note that in a portable alpha framework, the alpha-seeking manager is additive to the portfolio as long as they produce positive returns greater than the cost to finance the index exposure.

Understanding expected returns

Using the simplified example in the chart above, let’s assume that 100% of the target index exposure is created using market-linked instruments at a financing cost of 1.0%. Due to the fact that 40% of the index exposure is backed by physical cash (20% margin and 20% reserve), it can be reinvested in a cash rate to match the financing cost rate. Thus, the remaining 60% of exposure comes at a cost of 0.6%

Next, the alpha-seeking manager seeks some level of positive return. As 60% of the overall portfolio is invested with the alpha-seeking manager, the investor would receive 60% of the return generated by the manager. If the alpha-seeking manager targeted a 5% return, then the overall investment would receive the expected return of the target index and an additional 3% from the alpha source, minus 0.6% for the cash financing cost.

Overall, the investor’s return could equate to the market index return plus 2.4%

Putting portfolio capital to its highest and best use

The key advantage of a portable alpha framework is investors can untether a portfolio’s active risk budget from the beta allocation without disturbing it. Most importantly, it unlocks portfolio capital to seek excess returns in areas of the global financial markets with the highest potential to generate alpha. For investors, building the optimal asset allocation for the market return, or “beta” component, of your portfolio is quite different than the optimal capital allocation seeking excess returns, or “alpha” component, of your portfolio.

 

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Portable alpha unlocks portfolio capital to be used to seek excess returns in areas of the global financial markets that have the highest potential to generate alpha.

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Raffaele Savi Head of Systematic Investing

In equity portfolios, we find that market capitalization is a common driver of portfolio asset allocation weights, but it is not an optimal starting point for active risk allocation. In fixed income portfolios, we find that most managers have low active risk budgets and derive the majority of their active return from tilts into credit-sensitive securities—essentially delivering beta and a potentially high correlation to equities.

Portable alpha strategies can help solve these issues across both asset classes. They can allocate active risk based on other alpha opportunity sets in equities, and they can help construct a more diversified source of active return than traditional bond portfolios.

Case study: Fixing the alpha-beta mismatch in equities

The concentrated nature of capitalization-weighted indices is a difficult starting point for active risk budgeting, as it dramatically tilts the portfolio allocations away from the most diverse, high-breadth market segments. The figure below breakdowns the MSCI ACWI IMI into conventional segments in which clients typically organize their equity allocations.

While following capitalization-weighted indices can be a well-prescribed starting point for your overall equity market beta allocation, it can also have consequences on the effectiveness of alpha-seeking efforts. Most notably, the amount of capital allocated to active managers in each category is typically bound with its market cap weighting in the broader index.

For example, US Large & Mid Cap exposure is typically over half the overall equity allocation, while International Large Cap is roughly a quarter. The other more diverse equity segments, and where risk-adjusted returns potential may be greater based on top-quartile manager returns, combine to be just under 25% of the total equity exposure.

Market cap equity allocation is misaligned with alpha potential

MSCI ACWI IMI segment allocations and realized 10-yr Information Ratios of top-quartile managers

Learn more about market cap equity allocation.

Source: MSCI, eVestment, BlackRock as of 31 December 2020. “Typical % Equity Allocation” represented by the market-capitalization weights of the MSCI ACWI IMI Index. Information ratio is a measure of an active manager’s ability to generate risk-adjusted excess returns versus a representative market benchmark. “Realized Information Ratio” is the observed 10-year information ratio for the top-quartile managers in the eVestment database for each market segment. Indices are unmanaged and one cannot invest directly in an index. This is only an example of the potential of the investment strategy to be employed and does not take into consideration actual trading conditions and transaction costs. The figures are for illustrative purposes only and results cannot be guaranteed.

Manager selection can only go so far

In our experience, it’s a challenge to consistently find skilled, top-quartile performing managers and even exceptional manager selection is still bound by asset class limitations.

As shown in the figure above, if you were successful in identifying a top-quartile manager in the US Large & Mid Cap segment, the overall portfolio impact might be muted. Why? Selecting a top-quartile manager in the segment would have only resulted in an information ratio of 0.17 on about 50% of your total equity allocation. On the other hand, selecting a top-quartile DM International Small Cap manager would have been far more rewarding with an information ratio of 0.91, but that would likely only be a small portion (<5%) of your total portfolio.

Manager selection matters less if the starting point of an asset allocation is not aligned with alpha opportunities. Portable alpha can help with this alpha-beta mismatch.

Putting portable alpha to work in equities

What are the potential benefits of a portable alpha framework in equities? Broader opportunities to generate alpha in the largest parts of the portfolio where meaningful outperformance may be difficult.

Let’s assume we want to generate more return from a US Large Cap allocation. If we use a portable alpha approach to replicate S&P 500 beta exposure and make a 60% investment into an alternative strategy such as a global long/short market neutral strategy, the portfolio outcomes can be much more impactful than strong manager selection alone.

Global long/short market neutral strategies are typically high-breadth portfolios that are able to look across global equity markets for opportunities, not just a particular market segment like US Large Cap securities. Importantly, since these types of strategies take both long and short positions, they often seek to take advantage of security dispersion in markets, and do not add significantly more beta exposure. As a result, the returns can be less dependent on market direction. This type of uncorrelated return profile can potentially act as a compliment to the index exposure in up markets and a buffer against volatility in down markets.

The figure below compares the alpha generated by the top-quartile of US Large Cap Core equity manager to a portable alpha framework that replicates the S&P 500 Index through market-linked instruments while holding a 60% allocation to an alternative strategy, represented by the HFRI 500 Equity Market Neutral Index.

Traditional long-only results compared to a portable alpha approach

Hypothetical annual alpha generation based on approach

Read more about BlackRock’s portable alpha approach.

Source: eVestment database as of 31 December 2020. “Traditional Long-Only Approach” alpha data based on the 10-year average annual alpha generated over the S&P 500 Index for the top-quartile (25th percentile rank) manager in the eVestment US Large Cap Core category. “Portable Alpha Approach” alpha calculated as 60% of the average annual return of the HFRI 500 Equity Market Neutral Index (3.22%) minus 60% of the ICE BofA 3-Month Treasury Bill Index (0.63%) . The HFRI 500 Indices are global, equal-weighted indices comprised of the largest alternative funds published by Hedge Fund Research, Inc. Indices are unmanaged and one cannot invest directly in an index. This is only an example of the potential of the investment strategy to be employed and does not take into consideration actual trading conditions and transaction costs. The figures are for illustrative purposes only and results cannot be guaranteed.

As you can see, the realized 10-year annualized alpha of a top-quartile manager is 0.58%. In comparison, 60% of the HFRI 500 Equity Market Neutral Index return of 3.22% (which represents the average return of the managers in the category) results in an annual alpha of 1.93%. After adjusting for 60% of the 0.63% average annual financing costs of the beta exposure over the time period (as measured by the ICE BofA 3-Month Treasury Bill Index) the total alpha of the approach is 1.55% annually. As you can see, the unique structure of a portable alpha strategy may lead to greater return potential than what is possible through manager selection alone.

In a portable alpha framework, untethering alpha generation from the confines of capitalization-weighted asset allocations allows investors to optimize return potential away from segments of the markets that are typically the largest, but also the hardest to generate meaningful excess returns.

Case Study: Combating low yields in fixed income

Persistently low global fixed income yields and low return expectations create serious challenges for investors to meet long-term return objectives. To combat the low yield environment, many fixed income managers have resorted to “reach for yield” behavior—essentially going further and further down the credit quality spectrum to seek out extra yield to boost returns. But this type of strategy has consequences.

Source of active return matters

In the figure below, we regressed 15 years of Core and CorePlus manager returns against a simple three factor model which included credit risk, equity risk, and rate risk. We found that approximately 65% of Core managers and 70% of CorePlus managers’ excess returns were explained by these static exposures.

Bond manager excess returns largely explained by tilts to credit risk

Fixed income manager excess return composition

Learn more about equity allocation.

Source: eVestment database, as of 31 December 2020. Based on the active return versus the category benchmark over the past 15 years. This is only an example of the potential of the investment strategy to be employed and does not take into consideration actual trading conditions and transaction costs. The figures are for illustrative purposes only and results cannot be guaranteed.

Of the three factors, the credit risk factor exposure was most explanatory. This implies that many active Core and CorePlus bond managers have relied on an overweight to credit-sensitive securities to drive excess return. This has a very important, but often overlooked, effect on total portfolio diversification. The credit overweight may boost returns in up markets, but it may also result in larger fixed income drawdowns in periods of equity sell-offs—the very time when investors need the diversification of core bonds the most.

Putting portable alpha to work in fixed income

What are the potential benefits of a portable alpha framework in core fixed income? The ability to increase active returns and at the same time seek idiosyncratic, equity-diversifying return streams.

Instead of chasing yields in fixed income markets, using alternative strategies as the alpha source can help preserve the equity diversifying returns investors come to expect from bond allocations. Hedge funds that employ multi-strategies are more focused on idiosyncratic return streams that are the result of relative value or long/short security selection opportunities.

The figure below compares the alpha generated by the top-quartile Core and CorePlus bond managers to a portable alpha framework that replicates the given benchmark while holding a 60% allocation to an alternative strategy, represented by the HFRI 500 Relative Value Multi-Strategy Index. As you can see, the realized 15-year annualized alpha of a top-quartile manager is 0.80% and 1.04%, respectively. In comparison, a portable alpha strategy with a 60% allocation to the median multi-strategy manager would have resulted in total alpha of 1.74% annually, after adjusting for financing costs.

Comparing results of a traditional long-only and portable alpha approach

Hypothetical annual alpha generation based on approach

Learn more about the portable alpha approach.

Source: eVestment database, as of 31 December 2020. “Core Bond Long-Only Approach” alpha data based on the 15-year average annual alpha generated over the Bloomberg Barclays US Aggregate Bond Index for the top-quartile (25th percentile rank) manager in the eVestment US Core Bond category. “Core Bond Long-Only Approach” alpha data based on the 15-year average annual alpha generated over the Bloomberg Barclays Universal Bond Index for the top-quartile (25th percentile rank) manager in the eVestment US CorePlus Bond category. “Portable Alpha Approach” alpha calculated as 60% of the average annual return of the HFRI 500 Relative Value Multi-Strategy Index minus 60% of the ICE BofA 3-Month Treasury Bill Index. The HFRI 500 Indices are global, equal-weighted indices comprised of the largest alternative funds published by Hedge Fund Research, Inc. Indices are unmanaged and one cannot invest directly in an index. This is only an example of the potential of the investment strategy to be employed and does not take into consideration actual trading conditions and transaction costs. The figures are for illustrative purposes only and results cannot be guaranteed.

Once again, the structural advantage of the portable alpha strategy can translate to better returns even against top-performing managers in the category. During this time when investors are struggling with low return expectations from fixed income, portable alpha strategies offer a way for investors to increase the overall level of potential return from their core allocations. Equally important, portable alpha can help preserve the diversification benefits in a portfolio by seeking more idiosyncratic sources of return that are less correlated with credit risk.

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Learn how portable alpha strategies can help improve the risk and return outcomes in broad asset classes by putting your portfolio capital to its highest and best use.
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Raffaele Savi
Head of Systematic Investing
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Tom Parker, CFA
CIO of Systematic Fixed Income
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Shawn Steel, CFA
Sr. Product Strategist
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