Tuesday, October 13, 2009

Deporting Alpha?

Reuters reports that Massachusetts state fund drops four hedge fund firms:
Massachusetts will remove $1.6 billion from hedge fund managers Blackstone, Crestline, EIM Management, and Strategic Investment Group as it shifts its investment strategy after suffering recent heavy losses.

Trustees for the roughly $40 billion fund voted on Tuesday to pull out of four firms that used portable alpha, a once popular technique employed by pension funds to beat markets that underperformed during the financial crisis.

"This is a strategic shift and not a dissatisfaction with the individual managers," said the pension fund's chief investment officer, Stanley Mavromates.

The move comes at a time many big investors -- ranging from endowments to pension funds -- are rethinking their strategies after a brutal year where some trustees said they lost their taste for riskier investments.

Betting on portable alpha backfired badly for Massachusetts, costing the fund 46 percent during the year that ended on June 30. Massachusetts had long ranked among the best performing public pension funds.

The fund's trustees voted in August to scrap use of the strategy, but only decided on Tuesday which managers would be let go.

The state will likely have to wait until 2010 to get its money back. Many hedge fund managers, unlike mutual fund managers, return investments only periodically.

Mavromates said most funds should be back by the middle of 2010 and all will be returned by the end of next year.

Blackstone is expected to return $200 million while EIM will give back $172 million. Crestline will return $670 million and Strategic Investment Group will return $650 million, Mavromates said.


Even though Massachusetts, one of the first state pension funds to bet big on hedge funds, is abandoning portable alpha, it is sticking with loosely regulated portfolios and even plans to increase the amount of money it allocates to them by the middle of next year.

Since making its first bet on hedge funds five years ago, the state fund has seen an annualized return of 4 percent from those funds, far more than the 1 percent return delivered by the Standard & Poors 500 index during the same time.

"We are $1 billion better off because we bet on hedge funds," Mavromates said.

Massachusetts had allocated 5 percent directly with hedge funds and had a 6 percent portable alpha investment, for a total of 11 percent earmarked for absolute return strategies. Now the fund will allocate 8 percent to alternative strategies.

By the middle of 2010, Mavromates said the pension fund will have $3.2 billion in hedge funds, up from the $2 billion it has in right now.

Most of the money coming out of the portable alpha program will be redistributed among Arden Asset Management, K2 Advisors, Pacific Alternative Asset Management Company, Rock Creek Group and Grosvenor Capital.

The hedge fund of funds groups Arden, K2, PAAMCO and Rock Creek were among the firms that helped the state select which hedge funds to invest with.

After the chaos of the past few years, Mavromates is imposing new controls on these managers as well.

"Each manager will be more focused," he said. "They will have tighter guidelines that will play to their strengths." For example Rock Creek with be asked to focus exclusively on non-U.S. investment strategies.
Mass PRIM isn't the only pension fund that got hit from portable alpha activities. FierceFinance reports that CalPERS also suffered from portable alpha woes:

It's been a dismal year for pension giant CalPERS. The fund lagged the Wilshire large public fund universe median return by six percentage points for the 12 months that ended June 30, reports Pensions & Investments Online.

The culprit seems to be the "beta overlay" on its near $6 billion Risk Managed Absolute Return Strategies portfolio. The overlay seems to be an attempt to attain portable alpha-like gains to goose returns in order to align the overall portfolio with a more appropriate index, one that includes hedge funds' returns.

The effort was apparently managed internally, but it backfired miserably in the face of the global markets swoon. The effort began in May 2008, the article notes, and was compounded by a decision to go long in futures--which also backfired.

At the beginning of October, Giovani Legorano wrote an article for Global Pensions, Rethinking the approach to portable alpha and ended it off by stating:

Several industry figures also emphasised the ability of these strategies to provide diversification benefits to a plan’s portfolio. However, they also warned about the liquidity risk it might be associated with them.

Callin said: “Liquidity is a crucial component to a successful portable alpha approach, because while you are gaining asset exposure up front and not paying for it, if that asset value declines because of the way derivatives work investors will have to pay for the market decline. In other words, the collateral cost. Therefore you need to have that liquidity in your underlying strategy, in order to meet those margin calls – cash calls – when the market declines. We believe that appropriate liquidity management is a fundamental criterion of any portable alpha approach.”

Callin is absolutely right and one of the fundamental reasons why portable alpha strategies got trounced in 2008 was because fiduciaries underestimated liquidity risk of the underlying hedge fund strategies.

If Mass. PRIM was invested in liquid hedge fund strategies in their portable alpha portfolio, they wouldn't have been hit as hard and they wouldn't have to wait as long now that they're redeeming those funds. The liquidity mismatch cost them in 2008.

While portable alpha is theoretically appealing - beta is cheap so swap into equity and bond indexes and use the cash to invest in hedge funds that produce alpha - in practice it can turn out to be a nightmare, especially during a liquidity crisis.

How widespread is portable alpha among global pension funds? Nobody really knows but there are trillions in swaps underlying these portable alpha strategies. If counterparty risk ever exploded again, you'd need another mammoth bailout to make sure the pension system doesn't crumble.

[Note: I wouldn't worry but some have privately expressed serious concerns about pensions engaging in portable alpha and how it is yet another time bomb that can potentially derail the global financial system.]

But hedge funds are performing well this year so there are no immediate concerns on the portable alpha front. Pensions & Investments reports that hedge funds produced positive returns for the seventh consecutive month in September, but none of the major hedge fund indexes outperformed the S&P 500’s 3.73% return or the MSCI World’s 4.61% return for the month. No surprise there since hedge funds also have short positions so their gains are capped when markets are trending up.

According to the NYT's DealBook, the big hedge funds posted gains in September:

  • Moore Global Investments: +3.8 percent in Sept., +17.8 percent YTD
  • Paulson Advantage: +0.48 percent in Sept., +13.2 percent YTD
  • Capital Fund Management (CFM Stratus Fund 2x): +6.29 percent in Sept., +38.42 percent YTD
  • Tewksbury Investment Fund: +1.1 percent in Sept., +12.36 percent YTD
  • S.A.C. Capital International: +2.47 percent in Sept, +23.38 percent YTD
  • Winton Capital Management (Winton Futures Fund): +2.85 percent in Sept, -5.5 percent YTD
  • Tudor Investment Corporation (Tudor BVI Global Fund): +3.21 percent in Sept., +16 percent YTD
  • Balyasny Asset Management: +0.79 percent in Sept., +5.85 percent YTD
  • D.E. Shaw Oculus Fund: +0.4 percent in Sept., +10.2 percent YTD
  • D.E. Shaw Composite International: +1.1 percent in Sept., +18.1 percent YTD
  • Citadel Kensington Global Strategies Fund: +4.33 percent in Sept., +57.02 percent YTD
  • Caxton Global Investment Fund: +1.7 percent in Sept., +5.65 percent YTD
  • Serengeti Overseas Ltd: +5.3 percent in Sept., +67.9 percent YTD
  • Tremblant Partners: +1.08 percent in Sept., +25.76 percent YTD
  • Brevan Howard Fund: +1.42 percent in Sept., +16.15 percent YTD
These are impressive gains from top hedge funds but I wonder, how much of this is "true alpha" and how much of this is "disguised beta"? I suspect it's more of the latter.

You might be saying who cares? After all, money is money and the bottom line is they're producing strong returns. But when you're paying 2 & 20 to some hedge fund, you better make sure they're delivering true alpha or else you're overpaying for what is essentially leveraged beta. And that can come back to bite you when markets tank again.

Finally, Chris Holt, founder and editor of AllAboutAlpha, wrote on alpha being airlifted out of dying portable alpha strategies. I highly recommend you read it, including John Wartman's comment at the bottom of the page:
The beta component of a portable alpha strategy should have been recognized as leverage. The alpha component, usually a Fund of Hedge Funds, did better than the beta component but failed to adequately protect the downside, losing 15 to 20%. The idea of combining the strategies in portable alpha was a creation of misdirected “rocket scientists” whose mandate was to sell product. Any risk system or stress testing would have shown the compound loss potential due to the leverage.
Compound loss potential due to leverage? You don't say! That should be a topic of discussion in the trial of the two former Bear Stearns hedge fund managers that just got underway today. That, and outright fraud, of course.

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