2007 Ny Chotai I7

Portable Alpha Investment Strategies
Sandy Chotai Morgan Stanley Mike Holloway Northwestern Mutual
Traditional Approach vs. Portable Alpha Approach
Traditional Approach Set strategic asset allocation Determine manager structure (e.g., passive in efficient asset classes) Populate structure with suitable managers/strategies Opportunity for active management constrained by asset allocation decision
Portable Alpha Approach Determine overall risk budget Determine allocation between strategic and active risks Construct an optimal alpha portfolio seek alpha from a variety of uncorrelated sources, unconstrained by underlying asset allocation Determine optimal portfolio of betas and allocate allowing for any beta exposures already embedded in the alpha portfolio
Some or all beta exposure is obtained synthetically using futures, swaps, etc.
Portable Alpha
Mechanics and Return Composition
Alpha
Cash
Alpha
Embedded Beta2 Beta1 + Beta2
Derivatives
Returns
Beta1 Market Index Return
+
Management Fees
=
Funding Costs
Fees
Costs
Funding Cost
Fees to Intermediaries
Beta Overlay
Alpha Engine
Total Return
3
Portable Alpha Application
Beating back the Indexers
If you have access to alpha, why not use it? You can maintain the same asset class exposure
Alpha
Index Return
Index Return
Expand your (Efficient) Frontiers
Alpha diversity shouldnt be tied to beta diversity Alphas are typically uncorrelated to Betas or other Alphas Sharpe ratios are higher can choose risk cuts or return boosts
Return
Risk
Expand your (Efficient) Frontiers
(continued)
Hypothetical Insurance Company Asset Allocation Shift:
Equity Alpha
Equity Alpha
F.I. Alpha Fixed Income Market Return
Equity Market Return
Equity Alpha F.I. Alpha Fixed Income Market Return Fixed Income Market Return
Equity Market Return
90%
10%
80%
10%
10%
Optimize Precious Resources
Limited numbers of alpha generators can still run a diverse out-performing portfolio High alpha asset classes dont have to suffer from excess capacity because of beta constraints
Improved Asset/Liability Management
Improved pension asset/liability management:
buy down total portfolio risk
Increase duration-matched bond exposure at the expense of equities, while preserving expected returns by substituting active returns for the equity risk premium
Improved Asset/Liability Management (continued)

Tactical Small Cap Alpha Hedge Fund Alpha Large Cap Beta Currency Alpha
Excess Return Seeking Portfolio (risk budget)

International Equity Beta Systematic and Skill Based Return Sources Compete Side-by-Side Fundamental Betas Exotic betas Liquidity Premia Skill based alphas funded Skill based alphas overlays
Excess Return Liability plus
Liability Risk Mitigation
Liability Hedging Portfolio

Construct a portfolio comprising of cash and derivative instruments to reflect the economic characteristics of liabilities a blend of systematic factors: Interest rate Credit spread Inflation Economic growth Currency Etc.
9
Swaps
Bonds
Portable Alpha
Investment Tools
Derivatives! Some exchange traded capabilities (futures typically) OTC market Any derivative is really a combination of others Product needs to convert one exposure to something else
10
Portable Alpha Considerations
Finding a Suitable Alpha Engine

Alpha must be proven and sustainable assessment must be based on qualitative, forward-looking factors comfort in hiring/firing managers on this basis?
avoid biases inherent in historical data;
Capacity constraints as more capital flows in Risk is transferred too!
Ensure alpha being transferred is stable consider volatility and tail-risk Need to consistently outperform cash (funding cost of derivative) and other costs by a strong margin to make it worthwhile Is there sufficient transparency to be able to estimate embedded betas? Are betas and correlations stable?
Magnitude of alpha must outweigh cost of transporting
Ensure low or stable embedded betas
Is there adequate liquidity? What if I need to tap into my alpha portfolio to meet a margin call?
11
Constructing Beta Overlays
Trade-off between cost of obtaining synthetic beta and its ability to track the underlying cash benchmark the lower the tracking error, the higher the cost Ability to remove or obtain desired beta exposure: derivatives are most liquid and cost efficient in more efficient markets, but alpha is often sourced from less efficient markets Need to mitigate counterparty risk and timing of cash payment to counterparties (capital calls) Futures vs. swaps:

Costs vs. convenience Cash drag on portfolio vs. financing costs
12
The Usual Suspects
Risk Management: Strategy/portfolio construction - The crux of a successful strategy Firm specific - Internal authorities - Required Surplus - Risk Based Capital
Financial Reporting Tax
13
Operational Issues
Complexity of Structure need appropriate resources and infrastructure
Initial Set-Up

Buy-in from stakeholders Potential for misspecification of risk Need for rebalancing as markets move and realized active returns vary from expectations Continuing commitment from stakeholders if shorter-term performance is disappointing
Ongoing

14

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Portable Alpha Investment Strategies

Sandy Chotai Morgan Stanley Mike Holloway Northwestern Mutual

Traditional Approach vs. Portable Alpha Approach

Mechanics and Return Composition

Embedded Beta2 Beta1 + Beta2

Beta1 Market Index Return

Portable Alpha Application

Beating back the Indexers

Portable Alpha Application

Expand your (Efficient) Frontiers

Portable Alpha Application

Expand your (Efficient) Frontiers

Hypothetical Insurance Company Asset Allocation Shift:

F.I. Alpha Fixed Income Market Return

Equity Market Return

Equity Market Return

Portable Alpha Application

Optimize Precious Resources

Portable Alpha Application

Improved Asset/Liability Management

Improved pension asset/liability management:

buy down total portfolio risk

Portable Alpha Application

Improved Asset/Liability Management (continued)

Excess Return Seeking Portfolio (risk budget)

Excess Return Liability plus

Liability Risk Mitigation

Liability Hedging Portfolio

Portable Alpha Considerations

Finding a Suitable Alpha Engine

avoid biases inherent in historical data;

Capacity constraints as more capital flows in Risk is transferred too!

Magnitude of alpha must outweigh cost of transporting

Ensure low or stable embedded betas

Portable Alpha Considerations

Constructing Beta Overlays

Costs vs. convenience Cash drag on portfolio vs. financing costs

Portable Alpha Considerations

The Usual Suspects

Financial Reporting Tax

Portable Alpha Considerations

Complexity of Structure need appropriate resources and infrastructure

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