What are "Portable Alpha" and "Enhanced Indexing"?

Individual investors are increasingly being offered “portable alpha” and “enhanced indexing” products. Do they make sense for your portfolio? In this article, we will briefly review the meaning of these terms, and look at the performance of two interesting offerings.

Let's start with some basic terminology. When you invest in the stock of a single company, you are taking on two types of risk. The first is risk that is specific to the company itself. This risk has many different names, including idiosyncratic risk, specific risk, and unsystematic risk. The key point to keep in mind about this type of risk is that it declines as you invest in an increasing number of companies. This is the power of diversification. At some point (between 30 to 50 companies in different industries, depending on which study you are reading), company-specific risk is eliminated, and you are left with the core risk associated with investing in equities as an asset class. This is also known as systematic, or undiversifiable risk.

The total return from investing in a single company's shares therefore has two parts, which correspond to the return from taking company-specific risk and the return from taking risk associated with equities as an asst class. The specific breakdown between these two types of return is identified through linear regression analysis, which compares the returns on the specific stock to the returns on the market as a whole over a given period of time. This produces an equation for the stock's return, that is expressed in this form: Stock Return = alpha plus (beta times Market Return). Beta is a measure of a stock's exposure to the overall risk of investing in the equity market. A stock with a beta of less than one is less risky than the overall market, while a stock with a beta greater than one is more risky. The equity market itself has a beta equal to one. Hence, another name for systematic risk is beta, which (confusingly) is also used to describe the return you earn for accepting exposure to it.

The term alpha in this equation refers to the return you earn for accepting exposure to company-specific risk. As we have already noted, in the equity market as a whole, company-specific risk is diversified away. That also means that the return associated with accepting it must be zero for the equity market as a whole. This is what people are referring to when they say “alpha is a zero sum game.”

Now let's move on to how the term “alpha” is used by professional investors. As in the example above, it refers to a return in excess of what one would have earned simply by maintaining a constant exposure to one or more asset classes. To generate alpha, an active investment manager basically has two choices. He can select securities that will perform better than the asset class average, and/or he can time his investments in different asset classes based on his forecasts for their future returns.

People who hire investment managers naturally have a great interest in whether or not the managers are generating alpha. However, measuring a manager's alpha is not as straightforward as it seems. Probably the most difficult issue is determining the market return or returns that will represent compensation for systematic (beta) risk. Now why is this a problem? Here is a simple example. Let's say you hire an active manager to outperform the S&P 500 Index. To do this, the manager consistently tilts his portfolio toward stocks with low market to book ratios, which are also known as “value” stocks. Let's also say that the past year has been one in which value stocks outperformed the S&P 500. On paper, it looks like the manager generated significant alpha for you, and deserved the high active management fees you paid him. But was this really the case? If year in and year out, the manager's investment strategy consists of nothing more than systematically tilting towards value stocks, could not an investor have done this for herself by buying a fund that tracks the S&P 500 Value Index? Put another way, shouldn't the manager's performance be compared to this index benchmark, rather than to the S&P 500? In this case, the answer is probably yes, and the active manager's S&P 500 based alpha is therefore overstated, if it exists at all (for another example of this, see “Consumer Reports is Wrong” in our February, 2005 issue).

On the other hand, if the investment manager's tilt toward value shares was actually a tactical decision (e.g., the year before his tilt was toward growth stocks), then the S&P 500 was indeed probably the right benchmark to use when evaluating his performance. The point is this: the concept of alpha is not at all straightforward. Now let's talk about what it means to make alpha “portable.”

“Portable alpha” refers to the attempt to enhance the returns from taking systematic (beta) risk in one asset class (say, domestic equities) by adding to it alpha returns earned on investments in another asset class (say, domestic bonds). Here is a simple example of how this can be accomplished. Rather than simply investing $1,000 in an S&P 500 Index fund, our intrepid investor gives it to a manager of a “portable alpha” fund, who promises to deliver returns equal to some amount over the returns on the S&P 500. To do this, the manager first purchases $1,000 of S&P 500 futures contracts. However, since only five percent of these contracts' face value must be paid in cash, the investment manager will have $950 that can be invested elsewhere to earn alpha that can be added to the return on the S&P 500 futures. However, our active manager must also invest in such a way that he or she does not affect the investor's target allocations to different asset classes. For example, let's say our active manager plans to earn alpha in the corporate bond market, by going long bonds issued by companies whose credit quality is expected to improve (thereby triggering a reduction in these bonds' yields, and a rise in their prices) and selling short the bonds of issuers whose credit quality is forecast to worsen. To offset the increased exposure to domestic bonds in the investor's portfolio, our active manager could sell a $950 futures contact on government bonds.

So far, so good. However, our investment manager is still left with the rather large challenges associated with achieving consistent active management success. He or she must still possess either the superior information and/or the superior model that makes superior forecasting and positive alpha possible.

However, from the investor's perspective, “portable alpha” has a big advantage over the traditional choice between investing in either an index fund or an actively managed fund. By clearly separating the returns from taking systematic risk (which can be obtained at low cost via the use of index futures) from the returns from taking diversifiable risk (which logically should cost more), the investor will most likely see a significant reduction in the total amount he or she pays for investment management. This is a big improvement over traditional actively managed funds, whose high fees are assessed on the full value of the fund, even though a substantial portion of its returns come from beta risk exposure.

Let's now look at an actual example of portable alpha investing, to see how it has performed in practice. The Pimco Stocks Plus Fund has been in existence for more than ten years, and currently has nearly U.S. $1 billion in assets. Its objective is to deliver returns that are above those on the S&P 500. It generally seeks to earn alpha by investing in the bond market, where Pimco is regarded as one of the world's best active managers. The fund offers both institutional (PSTKX) and retail (PSPDX) shares. The former have an annual expense ratio of .65%, while the charge on the latter is 1.05%. We calculated the fund's alpha in each of the past ten years by subtracting the return on the Vanguard S&P 500 Index Fund (VFINX) from the return on PDTKX. Between 1995 and 2004, this alpha averaged .62% per year. However, additional risk was also taken on to earn that alpha. This risk is commonly measured as the standard deviation of the alphas, which is also known as “tracking error.” Over the past ten years, tracking error was 1.26%. The ratio of alpha to tracking error (or return to risk) is known as the Information Ratio (IR). In this case, it is .49, which is a very respectable number. However, it is also reasonable to ask whether this performance could have been due to luck rather than the active manager's skill.

The statistic known as the “T Ratio” helps us to answer this question. A T Ratio of 2.0 or more tells us there is at least a 95% chance that the reported performance is statistically different from zero, and therefore unlikely to be due to luck alone. The T-Ratio for an IR can be roughly estimated as equal to the IR times the square root of the number of observations used to calculate the IR. In our example, we used ten years of data, so the T Ratio is equal to .49 times 3.16 (the square root of 10), or about 1.56. This isn't quite 2.0, but it is close. Based on this analysis we conclude that PSTKX has delivered what it promised to its institutional investors - slightly higher than S&P 500 returns, with just a little more risk.

But should we expect the retail shares (PSPDX) to deliver the same results to individual investors? Unfortunately, they haven't been available for as long as the institutional shares. So, to answer our question, we have subtracted the additional .40% in expense charges on PSPDX from the returns on PSTKX, and once again subtracted the return on VFINX to estimate alpha, tracking error, and the Information Ratio. It turns out that those extra 40 basis points in expense charges have a big impact on the potential attractiveness of this portable alpha strategy. Alpha drops to only .22%, and the IR to .17. Under these circumstances, you cannot say with much confidence that the returns on PSPDX are statistically different from those on VFINX. There is also one other important difference between VFINX and PSTKX. Annual turnover on the former is only 3% per year, while on the latter it is 371%. If you own both funds in a tax-advantaged account, this difference doesn't matter. However, if you are holding them in a taxable account, VFINX will generate a far lower tax liability.

Hopefully, this example has clarified some important points. First, when offered a portable alpha investment, you should understand where the alpha is coming from, and how it is being generated. Second, you should also ask for the historical and anticipated tracking error and IR data, so that you can calculate your own T-Ratio. Finally, you should recognize the impact expenses can have on the attractiveness of a portable alpha strategy.

We have noticed that the term “enhanced indexing” is often used interchangeably with “portable alpha.” In many cases, this creates no problems. However, in some cases, enhanced indexing seems to signify something quite different than earning returns slightly above an index fund by taking on slightly more risk. Let's look at an example of this. One increasingly popular “enhanced indexing” is to invest in the S&P 500 Index, and then write (sell) covered call options against it. A call option gives its holder the right, but not the obligation to buy a share at a fixed price (the “strike price”) for some length of time up to a future date (at which time the option “expires”). A “covered call” option is one written on an asset that one already owns (if you don't own the asset, they are called “naked calls”). The value of a call option is primarily a function of three variables. The first is the strike price relative to the current price of the stock. The larger the positive difference between the strike price less the share price, the less valuable the call option to a buyer, because it is less likely to be exercised. When the share price is below the strike price, an option is said to be “out of the money.” When the share price is above the strike price, the option is “in the money.” And when the share price equals the strike price, the option is “at the money.”

The second variable that affects the value of a call option is the time until it expires. The longer the time remaining until expiration, the more valuable the option, because there is a greater chance it will be in the money at some point. The third variable is the volatility of the price of the stock underlying the call option. The higher the volatility, the more valuable the option, again, because of the greater probability that at some point the call option will be in the money.

The strike price, time to expiration, and volatility of the underlying share price are all taken into account when determining the current value of a call option. This is the maximum price (or “premium”) that the option buyer should pay for the option, and the minimum price the option seller should require. Since the strike price and time to expiration are clearly specified, the trading of options between buyers and sellers is logically based on their differing views about the volatility of the underlying share price. While historical volatility is a guide to estimating the right volatility to use when valuing an option, the inescapable fact is that volatility is not stable over time. Hence, it must be forecasted when valuing a call option, which gives rise to different views and the creation of option markets. Sellers of call options have a lower estimate for the future value of volatility than the people who buy them.

As we noted, one means of earning additional returns is to write (sell) call options on stocks that you already own. This is known as a “covered call.” The economic profitability of this strategy depends on the difference between the revenue you receive in the form of options premiums, and the returns that you forego when in the money options are exercised. For example, assume you purchase a share for $100, and then write a call option on it with a strike price of $110, in exchange for which you receive an option premium of $1. Further assume that the stock price then goes to $120, and the option is exercised. The return on your original stock investment is 11% , of which $10 is the capital gain on the stock and $1 is the option premium. However, had you not written the option, your profit would have been 20%. This illustrates a key point about covered call options: while you know for sure how much you are getting from selling them ($1), you can never be sure how much you might be giving up.

On the other hand, if the stock's price had only risen to $107, your return from wring the option would have been 8%, instead of the 7% from simply holding the stock. This shows why people write covered call options: to get more cushion against potential losses, even though they may be foregoing some future gains.

The Chicago Board Options Exchange (CBOE) has formalized the covered call strategy in the form of its BuyWrite (BXM) Index, which it introduced in April, 2002. Similar indexes have been introduced in Canada (MCWX) and Australia (XBW). The BXM tracks the returns from a strategy of buying the S&P 500 and selling slightly out of the money 30-day call options against it. Since mid-2004, a number of closed end funds have been launched that use this strategy, including one (ticker BEP) that tracks the BXM index and charges .90% in annual expenses. Let's now see how this strategy has performed.
We have estimated returns on BEP by subtracting its .90% expense charge from the historical returns on BXM provided by the CBOE. Over the 1995 to 2004 period, its alpha versus VFINX was (2.85%), with a tracking error of 10.52% for an Information Ratio of (.27). If an investor expects an investment in BEP to add alpha to the S&P 500, it seems likely he or she will be disappointed.

However, there is another way to look at BEP. The following table compares the performance of BEP and VFINX over the 1995 to 2004 period.

As you can see in this table, the covered call writing strategy substantially changes the nature of an investment made in large capitalization U.S. equities, reducing both returns and risk. We also compared the correlation of the real returns on both the BXM Index and the Wilshire 5000 Index with those on other asset classes between 1989 and 2004, and found they were generally very similar.

It therefore seems to us that, rather than being seen as an alpha adding strategy, BEP and similar funds are better seen as an alternative that could, if used as a substitute for a broad equity index fund, have a substantial impact on an investor's strategic asset allocation decision. We therefore plan to test the implications of substituting the BXM for a broad equity index (e.g., the Wilshire 5000) in the upcoming rebalancing of our model portfolios.

Finally, before using BEP or a similar fund to implement an allocation to equities, prudent investors have to ask themselves a critical question: why should we expect the attractive historical returns to continue in the future? More specifically, as the popularity of the funds based on S&P covered call writing increases, will the number of potential buyers for these call options also increase? And if this new demand fails to develop, and option premiums consequently fall, what will happen to the expected return and risk of the strategy? At this point, we don't have a clear answer to these questions, and neither does anybody else (e.g., see “Passive Options Based Investment Strategies” by Feldman and Roy).

| Equity Market Valuation Update | Investing in Foreign Currency Bonds | This Month's Issue: Key Points | What are "Portable Alpha" and "Enhanced Indexing"? | Global Asset Class Returns | Does Foreign Commercial Property Belong in Your Portfolio? | This Month's Letter to the Editor: Equity Market Neutral Hedge Funds vs Index Investing |