Passive investment in broad based indexes has been one of the more successful strategies in the investment world. After decades of outstanding growth in both assets under management and relative performance vs. active management, it was only a matter of time before financial wizards would begin to tinker with the passive recipe. Portfolio managers and financial engineers began to ask themselves that nagging question: How can we “enhance” index returns—i.e. how can we take excess returns or “alpha” and combine them or with cheap beta sources to enhance index performance?
Let’s begin by examining the way one can gain exposure to the S&P 500. We will use $50,000,000 notional amount as institutions such as pension funds and large mutual funds will often transact in large amounts. Figure 1 below demonstrates three methods for gaining exposure to the S&P 500.
The first way is through an ETF such as the S&P 500 Depositary Receipts also known as Spiders (Ticker: SPY). With the ETF trading around $280.00, it would require the purchase of 178,571 shares of SPY to equal $50 million in notional value. The second way is to purchase all 500 stocks in the S&P 500 in the exact proportion to their weighting in the index. With modern transaction methods and computers, one can execute a program whereby a large money manager could purchase each and every stock in the index to the tune of $50 million. With modern technology, this could be accomplished in a matter of seconds.
A third way is to simply purchase E-mini S&P 500 futures at CME Group. The E-mini S&P 500 has a current notional value of $140,000. Hence to buy $50,000,000 of notional exposure, one would need to purchase 357 contracts. With futures however, it is not required to put down the full value of the contract. Instead the investor is required to post performance bond margin. This margin is currently $6,000 per E-mini contract. So, 357 contracts x $6,000/contract would equal $2,142,000. Hence, you would gain the same $50 million in exposure yet only be required to post $2,142,000. All three investors have $50,000,000 in notional value exposure. But only one has the margin efficiencies that futures offer.
Which leaves the question, what could the futures investor do with the remaining uninvested $47,858,000? This is where the portable alpha strategy begins to take shape.
Portable Alpha basically combines a cheap beta source like S&P futures and an alpha source. The alpha source could come from (or “be transported” from almost anywhere: hedge funds, managed futures, small cap stock alpha, but usually comes from shorter duration fixed income instruments.) In its simplest form, it marries beta from stock index futures to the incremental returns of fixed income.
One important point; the fixed income or alpha strategy on the remaining $47,858,000 million must generate a return more than ICE LIBOR. S&P 500 futures contracts combined with merely ICE LIBOR returns will simply replicate the S&P 500’s return and generate no excess return. The idea is to enhance returns beyond the S&P 500. A skilled portable alpha portfolio manager could achieve excess returns of 25-50 basis points over the SP benchmark.
If your alpha source is indeed fixed income, it’s mandatory to have expertise in this area. PIMCO for example has been doing portable alpha since financial futures contracts were introduced. They are a firm that has a significant percentage of assets under management in fixed income instruments. Moreover, they are active all along the yield curve and the credit spectrum. So, if you were to “look under the hood” of their portable alpha program, you would see short duration instruments in treasuries, agencies, mortgages, sovereign debt and corporate debt within the fixed income portion. This mix provides the necessary excess returns consistent with a lower risk profile.
One of the great benefits of derivatives based portable alpha is flexibility. Whatever alpha source you choose can be ported not only onto large cap indexes such as the S&P 500, but also other beta sources such as the Russell 2000 index or the S&P MidCap 400 index. These beta sources are cheap and liquid and offer institutions such as pension funds and money managers great critical mass to execute futures based portable alpha programs.
Portable alpha can take many forms and unlike the examples used above, can be more complicated and have many moving parts. Below is a strategy of how one might transport alpha from a small cap stocks onto large caps such as the S&P 500. In research supplied by Panagora asset management (see figure 3 below), we outline how this might occur. The core beta position is S&P 500 futures. But the alpha source begins with finding small cap active managers that outperform their benchmark—typically the Russell 2000.
As an example, let’s say you can find a manager that consistently outperforms the Russell 2000 index by 400 basis points (4.0%) per annum. You invest a sum of capital in this manager, say $950,000. You then short $950,000 worth of the E-mini Russell 2000. This allows the strategy to isolate the 4.0% excess return irrespective of the market advancing or declining. It is hoped the manager continues to outperform in up and down markets and you are capturing his alpha in a unique way. Then, on top of this alpha source, you go long $1,000,000 worth of SP 500 futures (margin would be about 4-5 percent of notional) to complete the beta portion. In the end you have transported the excess returns of the active manager onto the returns of the S&P 500. In either up or down market, you should outperform the SP 500 benchmark by 4%. In the illustration, the S&P 500 rises 27%. Adding the 4% excess return from the small cap legs of the strategy gives you a 31% return overall.
In summary, portable alpha strategies have enjoyed good success over the long run and many pension funds and money managers utilize the strategy. PIMCO’s flagship StocksPlus fund for institutions returned 10.33 percent from May 1993 to Sept of 2018 while the S&P 500 returned 9.89 percent.* Their portable alpha fund generated 44 basis points of outperformance over a quarter of a century, a significant sum of money for any institution such as a pension fund or endowment/foundation.
*Source: PIMCO StocksPlus annual report, dated September 2018.
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