Pension and other institutional investment portfolios are typically constructed to generate returns from a combination of two factors: manager skill and the market.

Manager skill-driven factors are known as the alpha factor. They are based on security selection and are measured as the added value over the market benchmark. Market-related factors refer to the average performance of broad investment classes and are known as the beta factor.

What is Alpha Transport?

Historically, alpha factors have come from active managers in the asset classes within a fund’s long-term asset allocation policy. Active management is the pursuit of investment returns through asset allocation and/or stock selection that aims to outperform a particular market index or benchmark.

However, through the use of derivative instruments (such as futures and swaps) it is possible to earn the alpha that has been generated by a skilled manager without increasing exposure to the particular market in which the manager is investing. The process of combining manager skill (i.e., alpha) with the desired strategic asset allocation (i.e., beta) is referred to as Alpha Transport.

Here’s an example:

A Canadian investor has a long-term asset mix policy of 60% equity (30% Canadian and 30% global; all actively managed) and 40% domestic bonds. The investor would like to benefit from the added value generated by a manager of Canadian equities, but does not want to alter the long-term asset mix policy. Moreover, the investor’s bond allocation is managed passively, as he believes that there is limited opportunity to add value from active bond management.

The question is: How can you extract more of the Canadian manager’s alpha without affecting the portfolio’s equity mix, while taking into account the investor’s passive bond strategy? 

One answer is to allocate a portion of the current bond portfolio to the Canadian manager and simultaneously short sell an equal amount of Canadian equity futures and buy domestic bond futures. At the end of the term of the futures contracts, the investor would realize the alpha from the active manager, since the short position in the Canadian equity futures offsets the gain/loss from the “market” portion of the manager’s return, and the passive return of the domestic bond market is delivered by the long exposure to the bond future.

Original Sample Fund

Sample Fund with Alpha Transport in Place

Conditions for successful Alpha Transport

Successful Alpha Transport depends on the identification of reliable sources of potential alpha (either asset classes or investment strategies) and managers that can convert this potential into reality. Once the alpha source is identified, four key factors must be considered in order for an Alpha Transport strategy to be effective:

• transaction costs of implementing the strategy must not be prohibitive
• capacity must not be an issue;
• liquidity must not be an issue;
• there must be no material change in overall portfolio risk characteristics

The degree to which these factors contribute to offsetting the benefit of an Alpha Transport strategy depends on the particular alpha source that is being considered.  As such, it is important to carefully consider all four factors when developing the strategy.

Transfer mechanisms

Futures contracts: A futures contract is a forward contract that is traded on an organized exchange and is subject to the guidelines and rules applied by that exchange. Unlike the forwards market, the futures market uses a clearinghouse facility, requires margin payments, and has standardized terms. Using futures contracts as a transfer mechanism involves establishing a long futures position to replicate the required benchmark exposure.  It may also involve a short position in the futures market. In this case, a long-only manager is investing to remove the market impact. These futures positions have to be managed and re-established at the end of the term of the contracts and some cash will be required to fund margin positions.  Liquidity risk can increase as the size of the position grows, especially at the point of rolling the futures positions.

Swaps: A swap is an instrument that enables investors to exchange payment streams for mutual benefit. Payments can be based on interest rates, currencies, or equity returns. Swaps introduce counter-party risk into the structure. Implementation may be difficult, depending on the market exposure desired.

Alpha Transport strategies worth considering

An investment structure that utilizes Alpha Transport is likely to consist of the following components:

• a base portfolio driven by the investor’s liability profile represents the benchmark asset class;
• an alpha-generating structure, which may include traditional active mandates as well as alternative investment strategies; and
• Alpha Transport mechanisms used to transport the alpha into the structure.

The following Alpha Transport strategies are worth considering;

• Long-only in inefficient markets: One strategy is to invest in an equity or fixed income market where there is high alpha potential and to offset the market exposure with futures or swaps. This creates an alpha-only strategy.
• Absolute return funds or strategies: Absolute return strategies (those that target a positive return in absolute terms, rather than relative to an index or other benchmark) can be employed individually or via a Fund of Funds structure. The returns from such strategies will ideally be cash plus a margin (the alpha). In other words, they typically contain little or no market directional component.
• Tactical asset allocation and currency management: Tactical asset allocation and currency management are alpha-generating strategies used by several Canadian institutional investors. When structured as overlays, these strategies can be viewed as Alpha Transport strategies.

Alpha Transport is not science fiction

Alpha Transport is not a new concept. In fact, the underlying techniques have been used by investors for a number of years. These techniques can fundamentally alter the way in which an overall portfolio is designed. In particular, a total portfolio of diversified alpha strategies can be constructed, drawing on strategies from the most attractive markets rather than being limited to markets comprising the portfolio’s strategic asset allocation.

A portfolio with an Alpha Transport approach should not result in a combined strategic risk (beta) and manager risk (alpha) that is materially different from a traditional approach. However, the implementation of the structure does introduce unique risks. If these risks are understood and effectively managed, an Alpha Transport strategy could provide a more efficient overall portfolio than a traditional approach to portfolio construction.

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About the authors

Stephen Foote is a consultant in the Toronto office of Mercer Investment Consulting.  Stephen specializes in asset-liability modelling, asset mix reviews, the development of manager structures, and investment manager searches.

Jean Michel is a senior consultant in the Montreal office of Mercer Investment Consulting. Jean is responsible for Canadian strategic research and is the Canadian representative of Mercer’s Global Strategic Research Committee.