By Katie Gilbert
Few investment strategies have taken as much heat since last year’s crash as portable alpha, which pension managers employed in recent years in an effort to create enhanced index returns. Unfortunately, many have learned that there is no free lunch after all and have been dumping portable alpha in droves.
That’s exactly what happened with the $2.6 billion Fire and Police Pension Association of Colorado in Greenwood Village, Colo., which decided in August to wind down its portable alpha program. It’s not giving up on hedge funds, however; instead, it’s rolling over the fund of hedge funds used in its portable alpha exposure to a much bigger absolute return allocation.
Portable alpha is created when managers invest in market index futures, which require only a small cash margin, then use the excess money to invest in strategies they believe will boost those market returns, such as hedge funds. Colorado, which used the Russell 1000 futures for its market returns, launched its portable alpha program in November 2004, and explained the value of the structure in last year’s annual report: “By allocating a portion of fund assets to the portable alpha overlay strategy, the association is able to access these unique [hedge fund] strategies, while seeking to maximize returns in a risk-controlled manner.”
But instead of controlling risk, portable alpha added to it, largely because of the leverage involved. Colorado leveraged its portfolio on a one-to-one basis; for every dollar of exposure to the index, it added a dollar of exposure to hedge funds.
As a result, Colorado’s portable alpha program, which held $150 million going into 2008, lost 48% last year, greater than the 38% decline of the Russell 1000. Those losses were just part of the association’s $1.076 billion net loss last year. In 2008, the portfolio fell 28.85%, compared with the 24.91% decline of the average public pension plan.
The experience forced a recalibration of Colorado chief investment officer J. Scott Simon’s take on how hedge funds should be employed. ”We [have] recognized that our hedge funds can be a bit more volatile than what would be appropriate for a portable alpha structure,” he says. Simon stresses that he and the board weren’t so naïve as to think that hedge funds could never lose money, but he concedes that he was taken off guard by the magnitude of hedge funds’ collective drawdown in 2008.
The Colorado pension system joins several other funds that have recently decided to dismantle such programs in their portfolios. The $39.4 billion Massachusetts Pension Reserves Investment Management board opted in early August to get rid of its portable alpha plan, following similar action by the $55 billion Pennsylvania Public School Employees’ Retirement System and the $22.8 billion Pennsylvania State Employees Retirement System.
Simon’s problems with portable alpha haven’t led him to exit from hedge funds. Quite the contrary. As he sees it, hedge funds themselves are still a good bet for a balanced portfolio.
“I still believe that longer term, hedge funds are going to add a differentiated return stream from public equities or fixed income or other strategies,” he says. Now appears to be the time to rethink how hedge funds will be housed within the portfolio. Simon has recommended a new absolute return program that would comprise 10% of the association’s assets and would contain the system’s hedge funds.
Instead of getting additional exposure from portable alpha, this plan would require bringing in additional hedge funds, as the system now has 4% left over from its portable alpha program. The majority of the assets are invested in a fund of funds portfolio managed by GAM, and a portion with Gottex Fund Management, which it is liquidating. The system will look for fund of fund managers that complement the GAM fund of funds, such as global macro managers and short-biased managers. After a year or so, he hopes that the association will be able to invest directly in hedge funds.
Right now the breakdown is 38% in domestic equities, 26% in domestic bonds, 20% in international equities, 9% in private equity, 6% in real estate and 1% in cash. The portable alpha program was overlaid on the domestic equity allocation.
Since joining the association two years ago from the University of Colorado Foundation, Simon has streamlined the investment process so that the system could jump on opportunities and make changes in a timely manner. In keeping with this push, he will recommend that the new allocation include a 6% earmark to an opportunistic bucket, which initially will hold real assets and distressed strategies, but whose broader purpose will be to allow the system to pounce on investments that require swift action.
“In general, the fund was missing out on a lot of funds and strategies and allocations just because we couldn’t move quickly enough,” he says. If portable alpha was the way to overcome that problem, the events of last year proved something else is sorely needed.