Buy Side Challenged to Create Alpha

Terry Flanagan

Institutional money managers say that 2013 could be tough sledding when it comes to generating alpha, and are rejiggering their investment strategies accordingly.

As equities markets show renewed strength, it’s become harder to identify arbitrage opportunities.

“2013 is a more challenging investment climate than we’ve seen in recent years,” said Jim Keohane, president and CEO of Healthcare of Ontario Pension Plan (HOOPP). “Over the past five years, there have been lots of opportunities presented by market dislocations, but those dislocations are becoming harder to find.”

Jim Keohane, HOOPP

Jim Keohane, HOOPP

HOOPP posted returns for 2012 of 17.1 per cent, which boosted the pension plan to a record $47.4 billion in assets, compared to $40.3 billion at the end of 2011. This double-digit return increased HOOPP’s 10-year average rate of return to more than 10 per cent, one of the best long-term records among pension plans worldwide.

The most challenging objective is to generate equity-like returns without a meaningful correlation to the equity markets.

“What this really means is we are trying to generate a return commensurate with investing in risky assets that is not driven by the risk of the market,” said Eloise Yellen Clark, CEO of OmniQuest Capital, in an investor letter. “It is the ability to meet this challenging objective, commonly referred to as “alpha” or manager skill that is the differentiating and value-added factor in hedge fund investing.”

HOOPP uses a liability driven investing (LDI) approach, a risk management philosophy that considers both the plan’s liabilities and the fund’s assets together, and focuses on the risk of having insufficient assets to provide funding for members’ retirements.

“Our liabilities are our pension plan payments, and those payments are keyed to the rate of inflation,” said Keohane. “If we experience wage inflation, that increases the value of our liabilities.”

The LDI approach drives portfolio construction with the establishment of two broad portfolios: the Liability Hedge Portfolio, which is designed to hedge the major risks of the liabilities, and the Return Seeking Portfolio, which aims to add return by controlled risk-taking.

The Liability Hedge Portfolio, which invests in bonds and real estate, increased by $2.2 billion in 2012, with real estate delivering an overall return of 18%.

“The Liability Hedge Portfolio is designed around minimizing risk. We run a dynamic portfolio, so we do we will change depending on what we see in our opportunity set, as well as what risks we need to hedge,” said Keohane. “We own a lot of long-term bonds to hedge against interest rate decline, but that risk has already played itself out, so may want to reconfigure the portfolio to reduce the duration of our bond portfolio.”

The Return Seeking Portfolio increased by $4.6 billion in 2012, with the largest contributions coming from the long-term options strategy at $2.3 billion. The long-term option strategy, in which equity index exposure is combined with equity index options, is a major contributor to the return-seeking portfolio.

“We have a strategy of selling long-term options on the S&P 500 and hedging that with futures, so in options parlance, you’re delta long,” Keohane said. “Options volatility declined during 2012, which contributed to the profitability of that strategy.”

Equities were also a big contributor to the Return Seeking Portfolio, with U.S. equities contributing $643 million in 2012. “We see large cap public equities looking recently attractive relative to bonds,” Keohane said.

Many investors question whether it is even possible to generate alpha, “especially in a diversified portfolio such as a fund of funds,” said Yellen Clark of OmniQuest. “And, for good reason, it is indeed very difficult to create alpha. Idiosyncratic or security-specific risk is quickly diversified away, thus leaving most diversified portfolios only with market risk, or beta. In the absence of consistent, prescient market timing, this leaves investment returns subject to the vagaries of the market.”

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