Education

Understanding Portable Alpha Strategies

Passive strategies strive to match the performance of a market index. Portable alpha strategies go further, combining key benefits of active and passive management in an effort to enhance returns while also seeking to manage risk – important goals in today’s volatile markets.

What is portable alpha?

Portable alpha is an investment approach that provides target market exposure, while adding the potential for additional return, or alpha, through a separate investment strategy. Because the source of alpha is independent of the desired market exposure, it can theoretically be transported to any market exposure, hence the term “portable alpha.”

How does the strategy work?

In portable alpha strategies, market exposure is gained through market-linked instruments such as futures or swaps. These positions require only a small outlay of cash (if any), allowing the manager to both capture the market return and actively manage the bulk of the portfolio’s cash in a liquid strategy – an absolute return bond alpha strategy, for example – that may provide additional return. This arrangement is similar to buying a car or a house without paying the entire price up front. As with an auto loan or mortgage, there is a financing cost associated with buying market exposure using futures or swaps. This cost is usually tied to a short-term money market rate. The alpha strategy may outperform this money market rate in order to deliver excess return.

Why use a portable alpha strategy?

Investors may look to portable alpha strategies for the following reasons:

Opportunity for enhanced returns– Portable alpha provides both exposure to a target market, such as stocks or commodities, as well as the potential to outperform that market. The opportunity for additional return can be especially helpful in an environment in which traditional asset returns are expected to be muted.
Maintain an existing asset allocation– Investors can enhance their portfolios’ return potential without making dramatic alterations to a traditional asset allocation model.
Diversification benefits– Because the cash is invested differently than the target market exposure, investors may gain a diversification advantage, helping to manage portfolio risk. It is important to note that diversification cannot ensure a profit or protect against loss in a declining market. It is a strategy used to help mitigate risk.

What are the types of portable alpha strategies?

The portable alpha structure may be used in many combinations that may be appropriate for specific investment objectives (see examples in the illustration below). Investors can obtain their desired market exposure, or beta, to a range of large-cap, small-cap, international and emerging market, and custom equity indexes. They can also gain exposure to commodities and real estate via instruments linked to those asset classes.

The alpha-generating component, which should have low correlation with the beta component and reasonable liquidity, can vary as well. Because the assets invested in these strategies may be needed in order to meet any margin calls, the securities should be relatively liquid, with a focus on capital preservation. At PIMCO, we typically back our portable alpha portfolios with actively managed, high-quality liquid enhanced cash, absolute return bond, Treasury Inflation-Protected Securities (TIPS) or long-duration bond strategies.

Figure 1:

For illustrative purposes only
1 Equity index as specified by the investment guidelines
2 Financing costs are comprised of Fed Funds rate and a positive or negative spread to Fed Funds rate.
3 The return on the alpha strategy may be less than the short term money market financing rate, which would result in negative excess returns.
There is no guarantee that any targets, projections or forecasts as stated herein may be achieved. All investments involve risk including the possible loss of capital.

Manager skill and risk management are key

While portable alpha is a relatively straightforward concept, there are many factors to consider when implementing these strategies. Investment managers are required to have the experience and infrastructure to effectively maintain liquidity and meet cash flows associated with market-linked instruments, with knowledge of the regulatory and legal factors involved. A rigorous process for managing risk is critically important as well, including thorough counterparty assessment. Given these factors, we believe investors should look to a skilled, experienced manager when considering this type of strategy.

Tax considerations

Because portable alpha strategies use market-linked instruments to gain market exposure, there are some tax considerations to be aware of. For example, all gains or losses on futures may need to be calculated as realized for tax purposes; these gains or losses may affect either ordinary income or capital gains, depending on the contract. With swaps, the tax treatment varies depending on the terms of the contract. Investors may benefit by consulting with an investment professional before investing.

What are the risks?

It is important to understand some of the risks associated with portable alpha strategies. Investors in these strategies may experience greater losses or lesser gains than would be the case if they invested directly in a market portfolio – the S&P 500 Index, for example – if the alpha strategy underperforms the money market-based cost. Additionally, portable alpha strategies may not be perfectly correlated to their underlying benchmarks and/or market exposures over time, and the degree of variation could be substantial. Finally, it’s possible for these strategies to experience a negative return.

Disclosures

Past performance is not a guarantee or a reliable indicator of future results.

A word about risk: All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Diversification does not ensure against loss.

Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha. Portable alpha is an actively managed strategy employed by portfolio managers to separate alpha from beta by investing in securities that differ from the market index from which their beta is derived.

Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government.

Hypothetical illustrations have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve results similar to those shown. In fact there are frequently sharp differences between hypothetical results and actual results subsequently achieved by any particular trading program.

One of the limitations of hypothetical results is that they are generally prepared with the benefit of hindsight. In additional, hypothetical scenarios do not involve financial risk, and no hypothetical illustration can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation if any specific trading program which cannot be fully accounted for in the preparation of a hypothetical illustration and all of which can adversely affect actual results.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.

This material contains the current opinions of the manager, and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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