For a post-Covid world, quant fund revives a contentious idea

Crisis puts out-of-vogue practice of “porting” alpha back in play

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Supercharged returns: quants hope to boost alpha by using overlays

Quants at QMA, the $106 billion quant equity and multi-asset arm of US investment giant PGIM, think the outlook for investors with typical stock-bond portfolios is about the worst it’s been in a decade. So the firm has dusted off an old but contentious idea: ‘porting’ alpha from racier strategies into more run-of-the-mill portfolios.

So-called ‘portable alpha’ overlays – which QMA has begun pushing in recent months – employ derivatives to mimic part of an investor’s stock and bond positions, freeing up cash to put into hedge-fund-like market-neutral strategies.

It’s a way to boost returns when conventional choices hold limited promise, without sacrificing liquidity or diluting the strategic asset allocation to equities and fixed income.

Some investors may be uncomfortable with the leverage inherent in the technique, though.

“Our return expectations are lower for both stocks and bonds,” says Yesim Tokat-Acikel, managing director of multi-asset research at QMA. “Interest rates are very low – the short rate is about zero in many places and negative in some – and growth expectations are not stellar.”

The end of the “Goldilocks” era for both fixed income and equities will present a “perfect storm” for pension funds and endowments, she says.

Global stocks have earned annualised returns of nearly 10% and bonds about 4% since the financial crisis of 2008. “Unfortunately, the next decade may not be as good,” she says.

When porting alpha, QMA replicates part of a portfolio’s stock and bond allocations using futures contracts, typically posting 5% of the futures exposure as margin. The cash released can be put to work in alpha-seeking investments elsewhere, such as multi-asset alternative risk premia strategies. These aim for returns uncorrelated to stocks and bonds.

“It’s like buying a house. You don’t put down the full price of the home. You put down 10%, 20% and you can live in it. If you buy S&P 500 futures on the index, you only need to put 5% down, which opens up the possibility of using the remainder of the cash for other investment opportunities,” says Tokat-Acikel.

Will the implicit leverage in the approach put some investors off, though? Possibly.

The idea of porting alpha isn’t new. Notably it came into vogue before the financial crisis. But investors ran into trouble back then as a jump in margin calls forced managers to sell illiquid assets or gate redemptions.

QMA is taking a cautious approach to setting margin requirements, Tokat-Acikel insists. The firm assumes initial margin could double instantaneously on all the instruments it trades and that the alpha-seeking part of the strategy could experience drawdowns of one-and-a-half times its annualised daily volatility.

“Once we set the margin requirements with this large cushion, we monitor the initial and variation margin from our brokers and the exchanges daily. In our live trading experience, this has proven to be very manageable,” she says.

It’s like buying a house. You don’t put down the full price of the home. You put down 10%, 20% and you can live in it

Yesim Tokat-Acikel, QMA

The Covid crisis, which saw stock markets plunge more than 30%, central banks slash interest rates and oil futures trade below zero, tested the approach. Tokat-Acikel says it came through successfully. Initial margin increased by about 50% for US 10-year bond futures, while increases were over 300% for WTI crude oil futures from mid-February to mid-April. Margins on the S&P 500 almost doubled.

For an alpha-seeking multi-asset portfolio of currencies, bonds, commodities and equities, those moves translated to a 50% increase in initial margin: from around 4% to 6% of notional at the peak. That was in line with the firm’s expectations of a stress scenario.

“This last quarter was an interesting quarter,” Tokat-Acikel says. Investors worry about the effect of margin calls and whether the approach can survive a drawdown, she says. “We didn’t have to make additional margin calls.” In what has been an “obviously unusual environment, we lived through”.

QMA manages close to $1 billion in quantitative active return strategies using overlay structures, though not all of this is funded using cash freed up from stocks and bonds in the portable alpha format.

While Tokat-Acikel concedes that portable alpha strategies have come in and out of favour, she says QMA’s quantitative credentials give it an edge over non-quant competitors offering the approach.

“We have experience managing liquid, uncorrelated alpha sources. It’s much easier for a quant firm to port alpha without impacting [a client’s] beta,” she says.

QMA is not alone. Antti Suhonen, senior adviser at investment consultant MJ Hudson Allenbridge, says he’s seen firms proposing the idea of portable alpha recently.

As for the risk: the total investment – in stocks, bonds and the alpha-seeking strategies – exceeds the capital, he says, which exposes investors to levered returns as well as margin calls. That could mean losses, though levered gains could also be higher. The ‘alpha’ may also turn out to be correlated with equities.

Managed carefully, though, the idea is sound, he thinks.

“I know some very smart institutions that do something similar and consider it nothing but efficient use of collateral. They use the best instrument for gaining access to alpha and beta at any point in time given the varying relative cost of carry of cash instruments, futures and swaps,” Suhonen says.

Additional reporting by Rob Mannix

Correction, August 21, 2020: A previous version of this article misstated QMA’s assets under management. The firms manages $106 billion across its quant equity and multi-asset strategies. 

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