Accelerate Monthly – How Portable Alpha Can Enhance Investment Portfolios

September 14, 2024 – According to the S&P Dow Jones Indices SPIVA (S&P Indices Versus Active) Scorecards, which regularly evaluate the performance of active mutual funds against their respective benchmarks, more than 90% of actively managed large-cap equity mutual funds underperform the benchmark index over the long term. Statistically, turning to active long-only mutual funds for one’s equity allocation will likely result in underperformance compared to the equity index.

Portable alpha, also known as “return stacking,” presents investors with a much higher probability solution for obtaining outperformance from their equity allocations.

Portable alpha is an investment strategy that separates alpha (the excess return on an investment relative to a benchmark) from beta (the return associated with market risk). The idea is to “port” exposure to alpha, which is generated through alternative investment strategies uncorrelated to the broad market index, on top of beta exposure, obtained through low-cost, passive investments such as index ETFs or futures.

The goal of a portable alpha strategy is to generate excess returns (alpha) that are independent of market movements while simultaneously obtaining desired market exposure (beta) through low-cost, passive investments, with the result of outperforming the benchmark. By combining beta and alpha, the strategy aims to enhance overall portfolio performance, optimize risk-adjusted returns, and provide more flexibility in managing risk exposures.

Here’s a breakdown of how the strategy works:

1. Alpha Generation: A portfolio manager employs a strategy to generate alpha. This alpha generation is typically derived from an actively managed alternative investment strategy that is uncorrelated with market beta, such as arbitrage, long short equity, or trend-following strategies. These alternative investment strategies are designed to generate returns independent of market movements (i.e., uncorrelated to beta).
2. Beta Exposure: The investor uses a low-cost, passive instrument like an index fund or a futures contract. For example, investors might buy S&P 500 index futures to gain exposure to the broad equity market. S&P 500 index futures are considered capital efficient because they allow investors to gain broad exposure to the S&P 500 index with a smaller initial capital outlay than directly purchasing the underlying stocks or the index ETF. This efficiency arises from the use of leverage and margin in futures contracts, which enables investors to control a large notional amount of assets with relatively little capital.
3. Combination: The “portable” part comes from combining the alpha and beta components. The combination allows investors to achieve baseline returns associated with the broad market index stacked with the alpha-generating returns on top. As long as the portable alpha strategy earns a return in excess of the investor’s funding cost, the portable alpha strategy will outperform.
4. Hedging and Diversification: The strategy often includes a hedging effect to protect against market volatility, creating a more robust, diversified portfolio. The flexibility of portable alpha strategies allows them to be adapted to various asset classes.

How Pairing Low-Cost Beta with Portable Alpha May Be Better for Allocators than Active Equity Management

 

Allocators, such as pension funds, endowments, family offices, and investment advisors, are increasingly looking for ways to enhance returns while minimizing costs and risks. Pairing low-cost beta with portable alpha has several advantages over traditional active long-only equity management:

1. Cost Efficiency:

• • Low-Cost Beta: Beta exposure can be achieved at a minimal cost using passive instruments like index funds, ETFs, or futures. These instruments have significantly lower fees than actively managed equity funds.
  • Lower Total Costs: By separating alpha from beta, allocators can manage the costs of each component independently, often resulting in a lower total expense ratio compared to traditional active equity management.

1. Flexibility in Alpha Strategies:

• • Customizable Alpha Sources: Allocators can choose from various alpha-generating strategies not confined to equity markets. For instance, an allocator can invest in a market-neutral hedge fund or a managed futures strategy to generate alpha while maintaining beta exposure through low-cost passive instruments.
  • Diversification Benefits: Because alpha strategies are typically uncorrelated to the market, combining them with passive beta exposure may reduce overall portfolio volatility and provide a more diversified return stream.

1. Higher Risk-Adjusted Returns:

• • Improved Sharpe Ratio: By blending low-cost beta exposure with potentially higher-yielding alpha strategies, investors may achieve better risk-adjusted returns than a standard actively managed equity portfolio.
  • Targeted Risk Exposure: Portable alpha strategies allow investors to be deliberate about their risk exposures. For instance, they can choose to leverage beta exposure in certain asset classes while simultaneously managing downside risk through alpha strategies.

1. Performance Consistency:

• • Less Reliance on Market Conditions: In a typical active equity management strategy, a significant portion of returns is often derived from the market’s performance (beta). With portable alpha, the focus on uncorrelated alpha strategies can provide more consistent returns across varying market conditions.
  • Better Downside Protection: Many alpha strategies, such as arbitrage or long short equity, are designed to perform well in up and down markets, providing a buffer against market downturns and reducing overall portfolio drawdowns.

1. Transparency and Control:

• • Greater Control Over Portfolio Construction: Allocators can control both their beta exposure and alpha generation, creating a more transparent and customizable portfolio. In contrast, traditional active management often involves a “black box” approach where the allocator has limited visibility into the sources of return and risk.
  • Transparency in Costs and Fees: Costs associated with low-cost beta are well-defined and predictable. A portable alpha strategy only pays an active fee for the alpha component, while traditional long-only equity managers mainly charge premium fees for beta exposure.

 

Constructing a Portable Alpha Sleeve

First, we select the beta component, or the passive allocation we want to track. For example, below we select a traditional 60/40 portfolio featuring a 60% allocation to a blend of the S&P 500 and TSX 60 stock indexes, with 40% allocated to the Vanguard Total Bond Market Index Fund ETF.

Second, we select the alpha component(s) that we will stack on top of the base beta exposure. When choosing an alpha exposure, it is essential that the strategy is either uncorrelated, or negatively correlated, to the beta exposure. Uncorrelated return streams help provide diversification benefits and smooth overall portfolio volatility, reducing the impact of market swings and improving return consistency. Diversification means that when one component (beta) experiences a drawdown or underperforms, the alpha component may still generate positive returns, thereby stabilizing the portfolio’s overall performance.

For the alpha component stacked on top, we equal-weighted two uncorrelated alternative strategies:

• Absolute Return (beta-neutral long short equity): 50% of the alpha sleeve
• Arbitrage (merger and SPAC arbitrage): 50% of the alpha sleeve

Since April 2020, the 60/40 balanced portfolio (grey line and bars below) generated a 9.0% annualized return, while the portable alpha portfolio (60/40 + 50% absolute return + 50% arbitrage, net of funding costs) produced an 18.1% annualized return.

Over the timeframe of the analysis, the portable alpha portfolio generated more than double the return of the beta portfolio.

Notably, the significant increase in portfolio performance of the portable alpha allocation was not derived from an increase in risk.

While the volatility of the portable alpha portfolio increased (from 10.4% for the beta portfolio to 13.8% for the stacked portfolio), the downside capture was reduced by more than 10%, and the portfolio’s consistency increased, with its number of positive months increased by 4%.

In addition, during challenging markets such as 2022, when the balanced portfolio fell by -12.7%, the portable alpha allocation outperformed, falling by just -9.5% (outperforming by 320bps).

Source: Accelerate, Bloomberg

• Accelerate Arbitrage Fund (TSX: ARB): Merger Arbitrage
• Accelerate Absolute Return Fund (TSX: HDGE): Absolute Return
• Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC): Multi-strategy
• Accelerate Canadian Long Short Equity Fund (TSX: ATSX): Long Short Equity
• Accelerate Diversified Credit Income Fund (TSX: INCM): Private Credit

ARB was flat in August, compared to the 2.4% rally in the S&P Merger Arbitrage Index.

The higher return of the benchmark merger arbitrage index was primarily due to the favourable regulatory result of the proposed Hawaiian Holdings acquisition by Alaska Air Group. This high-risk transaction appeared to be heading to a regulatory challenge by the Department of Justice, which is fresh off the successful block of another airline merger (Sprit Airlines / JetBlue Airways, which was terminated in March). Surprisingly, Hawaiian Holdings cleared the DOJ’s regulatory review and its stock price surged by 35.4% for the month. In addition, other high-risk M&A deals rallied in sympathy, further buoying the benchmark index.

Comparatively, we believe the ARB portfolio represents a much “safer” allocation to merger arbitrage, given the Fund’s avoidance of many of the high-risk segments of the merger market. That said, when some of these coin-flip odds transactions pan out, the Fund will underperform. Over the long term, we believe that a low-risk approach will maximize risk-adjusted returns.

Nonetheless, ARB remained active in August, adding two U.S. merger investments and three Canadian (including one subscription receipt arbitrage) to the portfolio. In addition, ARB participated in five of the nine SPAC IPOs that debuted in August.

The Fund remains fully deployed at 140.3% long and -12.4% short (152.7% gross exposure), with 41% allocated to merger arbitrage (split evenly between strategic deals and leveraged buyouts) and 59% allocated to SPAC arbitrage.

ONEC fell -0.4% in a mixed month for diversified asset allocation.

The real asset bucket was the largest positive contributor, with the real estate and infrastructure allocations gaining 3.7% and 2.1%, respectively.

In the inflation protection segment of the Fund, gold gained 3.6%, partially offset by ONEC’s allocation to commodities, which fell -0.5%.

Regarding ONEC’s hedge fund allocations, risk parity led the pack with a 2.0% rise, followed by absolute return, which was up 1.7%. Both Canadian long short equity and arbitrage were flat.

Lastly, the Fund’s credit allocation declined -1.7% in a volatile month for private credit. In addition, 40% of ONEC’s asset class allocations are U.S. dollar denominated, and currency exposure contributed to the overall negative performance of the Fund as USDCAD declined -2.3% in August.

ATSX returned -0.1%, while the benchmark TSX 60 gained 1.7% last month.

While all Canadian long short factor portfolios generated alpha in August, most of the top decile-ranked long portfolios underperformed the equity benchmark (although outperformed all of the bottom-ranked short portfolios). The multi-factor long short performance was primarily driven by the price momentum and trend portfolios.

The Fund’s 150/50 exposure underperformed in aggregate as the positive contribution from the short portfolio did not sufficiently offset the underperformance of the long portfolio within ATSX. Basically, the long portfolio underwhelmed last month, and while the short portfolio underwhelmed even more (to the Fund’s benefit), it was insufficient to provide a positive monthly return.

Private credit, a U.S.-centric asset class, faced two headwinds in August.

First, the bout of market volatility caused yields to increase and NAV discounts to widen. Second, the U.S. dollar weakened (as funding currencies such as the Canadian dollar rallied), causing INCM’s U.S.-focused loan portfolio to decline in CAD terms.

INCM’s twenty-one underlying private credit holdings have all completed the reporting of their Q2 results and quarterly loan portfolio performance. Overall, the underlying credit quality has been solid, however, three credit funds suffered a challenging second quarter. Both Oaktree Specialty Lending and Goldman Sachs BDC suffered NAV write-downs in the single digits, while BlackRock TCP Capital’s net asset value fell nearly 10%. In aggregate, INCM’s underlying fundamental NAV declined by -1.0% due to loan write-downs, and -2.3% due to currency, by month end.

Currently, the Fund’s underlying loans have an average yield of 11.5%, of which 85.8% are senior secured and 92.3% are floating rate. INCM is trading at a -4.1% discount to its underlying fundamental NAV (i.e. the value of its underlying loans at the end of the second quarter).

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-Julian

Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.