Jeleze Hattingh, Southchester Investment Managers
Donald Rumsfeld, who was both the oldest and the youngest secretary of defence for the US, famously stated in 2002 that “reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; these are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tends to be the difficult one.”
We now constantly live in the proverbial Chinese interesting times, with what used to be called extreme events occurring on a more frequent basis. Our market is awash with volatility as investors with different strategies try to price the known knowns and known unknowns (just think about the renewed focus on the tipping point of US inflation, anticipation of the timing of global interest rate normalisation, the Northern Hemisphere’s energy and gas crisis that is starting to rear its head, and the potential butterfly effect of Chinese policymakers allowing EverGrande to default).
It is however the “unknown unknowns” that we as investors should focus on, given that during extreme events, correlations across asset classes tend to move to 1, and liquidity dries up. The usual approach from investors to safeguard their assets is to build a long-only diversified portfolio, which under normal circumstances will serve them well, but under extreme market events tends not to provide too much protection. In this article, we want to offer an alternative to the typical long-only diversified portfolio by revisiting an old favourite that fell out of favour during the 2008 Global Financial Crisis, but that is slowly starting to make a comeback: portable alpha strategies.
What is a portable alpha strategy?
At its most basic, a portable alpha strategy allows investors to add a separate alpha component to a beta-yielding passive market investment, where the alpha component has little to no correlation with beta/the market.
Surveys by Russell Investments Group showed that in 2003, portable alpha was relatively unknown. However, by 2008, 22% of North American institutions had portable alpha allocations and 45% considered it. The market darling status didn’t hold for long, and investors threw in the towel after the GFC as the cornerstone of low correlation didn’t hold.
Some of the more notable headlines indicating the shift in sentiment included “You can PORT your ALPHA and eat it” during the heydays, shifting to “portable alpha is like synthetic Russian roulette”.
What went wrong with portable alpha as a strategy and how to mitigate the risks
- Correlation and drawdowns
The most important assumption is that the alpha components should have little correlation to the beta component, and drawdowns in the beta should be offset by the alpha returns. However, during the GFC tenure, “conservative” hedge fund of funds (that were typically used as the alpha component) lost 19% on average vs the equity market (beta) that lost 37% during the same period. Even though the drawdowns on the alpha components were not as severe as the market, there was still an observed c.0.5 correlation that led to disillusionment with the strategy.
Take-away 1: Target alpha components with low beta correlation and drawdown history
- Market volatility and liquidity
If derivatives are used for the beta component, the portfolio will be exposed to daily market movements and potential margin calls. As such, a portion of the fund should be kept as a cash reserve to cover these margin calls. However, if the cash reserve is exhausted, the alpha components must be liquidated to cover margin calls. If there is not sufficient liquidity, the beta components will have to be liquidated leading to potentially forced selling of assets, which can push the drawdown performance even lower.
Take-away 2: Target alpha components with high levels of liquidity
- Consistent and replicable alpha generation
The chosen alpha components must have proven and stable returns over various market cycles, consistently outperforming cash. Investors should be aware of doubling up of risk (correlation between asset classes) and the hidden effects of gearing.
Take-away 3: Target alpha managers with consistent returns and transparent investment strategies
- Excessive fees
Portable alpha strategies usually have a high fee structure, and as such any excess return can be easily eroded by fees (specifically performance fees against low benchmarks).
Take-away 4: Target alpha strategies with transparent fee structures
We believe that there is still a case to be made for portable alpha strategies in order to provide diversification and protection for not only some of the “known knowns” and “known unknowns”, but also for some of the “unknown unknowns”, provided that the risks, as identified and discussed
above, are considered and incorporated. We further believe that fixed income hedge funds as an asset class can be perfectly positioned as alpha components.
Building a basic portable alpha strategy:
Firstly, let’s start by looking at a basic example with the assumption that the overall target return = ALSI (beta) + 2% (alpha).
It is well known that ever since the emergence of the GFC and the avalanche of cheap money, active long-only equity managers have struggled
to outperform the market, which led to the near disappearance of traditional value managers and their replacement with passive offerings. Even though this has strengthened the argument for passive vs active at this point in the cycle, it should be noted that the stated return profile will never be achieved through long-only passive (beta) investments alone, as a passive portfolio will always underperform the benchmark due to fees.
We thus turn to the portable alpha strategy. It is possible to replicate beta (the market index performance) using derivatives, albeit ALSI futures, options, total return swaps, etc. This results in little upfront cash being needed, thereby making available extra capital which can be invested in the separate alpha components. Excess return is then generated if the alpha components’ returns exceed the costs associated with using derivatives.
To build an indicative R100 million portable alpha strategy, we could use the following building blocks:
- Buy 173 ALSI Futures for 99.6% effective exposure to FTSE/JSE Top 40 Index on SAFEX
- Initial margin of c. R8m
- Keep an additional R22m in cash reserves
- Remainder of R70m to be invested in alpha strategies
This strategy will outperform the market’s return if the alpha components’ returns are more than the combined cost of derivatives plus any fees.
One then needs to determine the targeted level of performance from the alpha components:
- As stated above, let’s assume total portfolio target = beta + 2%
- Assume cost of funding = repo rate
- Assume cash returns = average money market fund return over past five years = repo + 0.9%
- Lastly, assume a flat management fee of 1% across the portfolio
To obtain the desired beta + 2% return, the alpha components must return at least repo + 4%.
The next step to building the portable alpha strategy, is to determine the building blocks for the alpha component. Typical portable alpha strategies (and their main “known” risks) in South Africa include:
- Enhanced income funds/money market funds
Main risk: Not sufficient alpha generation. As an example, for the five years until the end of 2020, on average only 5% of enhanced income funds outperformed the required Repo + 4% target per calendar year.
- Absolute return strategies
Main risk: Potentially doubling up on risk due to asset allocation correlation
- Unlisted credit/infrastructure project funding
Main risk: Low liquidity
- Risk premia (long/short) hedge funds
Main risk: Beware “hidden” correlation with the market, with the correlation to the ALSI Top40 TRI being between 0.13 and 0.9, with a median correlation of 0.68. Furthermore, similar to the enhanced income funds, only 25% of long/short hedge funds outperformed the target of Repo + 4% over the past three years until the end 2020.
- Fixed income hedge funds / fund of hedge funds
Main risk: Potential volatility spikes due to correlation with the market, highlighting the importance of understanding the investment strategy and drivers of return.
To summarise the process that has led to the focus on hedge funds (and specifically fixed income hedge funds) as a strong contender for inclusion
as the alpha component, it is easiest to portray it graphically (see column chart).
Understanding the nuances behind the fixed income hedge fund asset class
As discussed above, three of the main cornerstones of a portable alpha strategy are the importance of low correlation with the market (beta return), low volatility, and consistent outperformance of the required target benchmark.
Looking at the correlation with the market as a starting point, we compared the correlations of South African fixed income hedge funds with the ALSI as well as the ALSI Top 40 over the past three years until the end of August 2021. With correlations ranging from -0.24 to +0.57 (and a median correlation of 0.25), it highlights the need to understand the strategy behind the various fixed income hedge funds, and the potential hidden correlation.
Secondly, we looked at the monthly returns over the past three years of South African fixed income hedge funds. Although most funds outperformed the benchmark of Repo+4% over the past three years, the volatility of the returns varied substantially. It is especially notable that not
all fixed income hedge funds behaved the same during the March-April 2020 period (also known as South Africa’s liquidity crisis at the start of the Covid lockdown period), which highlights the need to understand and incorporate liquidity and drawdown history.
And as for choosing a specific fund, it is our belief that the Southchester Smart Escalator Prescient QIF fits all the criteria. The fund has a conservative, low-volatility strategy that is easy to understand, whilst the Southchester management team specialises in liquidity risk management. The fund has very low correlation with the ALSI and has delivered consistent returns in excess of 12.5% since inception in 2017 – this equates to Repo + 7% through the last five years’ market cycles.
In conclusion, we believe that there is a strong argument to be made to include fixed income hedge funds in a portable alpha strategy, especially after taking the known knowns and the known unknowns of the various strategies into account. Copyright. HedgeNews Africa – October 2021.
Jeleze joined Southchester Investment Managers in 2020 as a portfolio manager and has over 19 years of investment experience specialising in fixed income, asset allocation and the alternative investments (property and preference share) universe. Jeleze is both a CFA and CMT charter holder, and obtained her Masters degree (cum laude) in 2002 in Business Mathematics and Information Science, specialising in Quantitative Risk Management.
