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Collective Investment Schemes: Separating Alpha From Beta
Malaysia Perspective | 07 December 2010
By: Andy Chiok
Articles (1) Profile

In order to outperform each other, traditional ‘long only’ funds are coming up with trading tactics designed to generate tracking error. Andy Chiok takes a look at some of the more common ‘tricks of the trade’.

The iShares MSCI All Country Asia ex-Japan Index Fund (ETF) has risen 1.4 times since the low of 24 October, 2008. Likewise, the SPDR S&P 500 Index ETF has risen 40% over the same period. Needless to say, stocks are no longer cheap and will get more expensive. From Allianz Global Investors to iFAST Financials, portfolio managers and analysts alike are overweight on equities. But at double digits Price Earnings Ratio (PER), the prudent investor may find it difficult to inject fresh funds into the market.

These days, portfolio managers managing ‘long only’ funds are also finding it very trying generating tracking error. With their restrictive mandates, there are only a few counters that managers can buy when pursuing a sector rotation strategy. At a fund update session to financial advisors, Andrew Mattock, portfolio manager for Henderson Horizon China Fund, points out that the bigger funds (in China) are very restricted and slow when they re-shuffle their portfolios and even then, one can guess at the ‘big names’ that these funds are ‘permitted’ to buy into.

Perhaps in response to this, more and more traditional ‘long only’ funds are embedded with derivatives in order to generate tracking error. Some of these, like Western Assets Asian Opportunities Fund, are invested in interest rates swaps, both deliverable and non-deliverable forwards, cross- currencies swaps, and the likes, while others, the Henderson Horizon China Fund for instance, have portions of their portfolios allowed for ‘short positions’ and the involvement in options (in this case, the purchase of put options), when the situation warrants it.

What Are Derivatives?

Derivatives are financial instruments that derive their value from the expected future prices of assets that they are linked. These assets can be shares, currencies, or commodities. Derivatives have no value on their own although some of the more common ones are being traded over exchanges and/or through inter-dealer brokers.

As derivatives are highly geared, a small movement in the price of the underlying assets will result in large movements in the price of the derivative. If speculated correctly, this can bring about huge profits. Hedging is another area where derivatives can be deployed. Risk can be mitigated by entering into derivative contracts whose values move in the opposite direction to their underlying positions. These are the two main reasons why portfolio managers are looking to derivatives for superior returns.

How Does It Work?

The Asian Opportunities Fund is an Asian focused fixed income fund that is traded in the local currencies of the fixed income instruments that it holds rather than US dollars. Depending on the portfolio managers’ outlook towards yield curves (of interest rates) in the region, swaps (both for interest rates and currencies) are deployed to maximize gains. This is a straightforward tactic where the direction of the derivative must be in alignment with the value of the underlying assets. This “Blowing with the wind” tactic can bite both ways though. When asked if it is possible that such tactics can result in the financial derivatives ‘eating’ into the value of the fund, a portfolio manager who runs a similar fund and has asked not to be named says that after the Merrill Lynch shock, “Anything can happen!” – a comment that you will not hear just three years ago.

Scenario Two where derivatives can be deployed is more relevant to today’s market conditions. When the price of risk is very high, the portfolio manager may want to hedge his positions. Rather than selling A stock for B, he may maintain his long position and simply purchase a put option. A put option gives the buyer (of the option) the right (but not the obligation) to sell the underlying stock at a specific price. Two things can happen: if the price of the stock continues to rise, the manager will simply let the option expire but if the price of the stock should tank, head south past a certain price (the strike price), and the put option is ‘in the money’, the seller of the put is then obligated to buy the underlying stock at the strike price – that is, the portfolio manager is now ‘short’ and this will cancel out the long position that he has in his original portfolio.

Other than the option of deploying options, which Mattock agrees is one of the trading strategies available to him but has not been exercised yet, The Henderson Horizon China Fund is unique in another respect: it also maintains ‘short’ positions in the portfolio. In an update to advisors dated 30 September 2010, the fund maintains 49 ‘long’ and 17 ‘short’ holdings. This is besides the ‘short’ positions that it has in futures contracts.

This is not to say that the fund is a big “No, No”. In fact, the Henderson Horizon China Fund is ideal in times like now when valuations are high. It allows the manager the flexibility to sell some parts of the portfolio and plough the proceeds into emerging themes or booming sectors. The deployment of options and futures also maintain a certain balance to the fund.

Perhaps the more important issue in investment is the ability to separate beta and alpha returns as it allows specialized teams to focus on their specific skills. Hubert Keller, Managing Partner at Lombard LLC says that investors should be interested in their asset managers’ investment model and must not hesitate to ask how their managers differentiate themselves from the competition. “After the last two years which have been terribly challenging for the asset management industry, more and more investors are looking for asset managers with a strong and specific investment philosophy,” he adds. Other than the alternative investment sphere, it seems that funds embedded with derivatives might just be the answer.

What, then, does the expert say? How can such portfolios add value to asset allocation?

According to Keller, strategic asset allocation will be the key to future returns. The portfolio construction process can be strongly improved by using a risk balanced approach focusing on equally weighted risk contribution rather than the traditional capital allocation framework. In other words, investors should distinguish beta generation from alpha generation. On one side, they will rely on low cost beta providers and on the other side they will look for specialised asset managers with proven and consistent alpha generation capabilities.

At this point, it is interesting to note that not all investors are in favour of seeking active returns to their investments. It seems that Investment returns are taking a back-seat to risk management and stability concerns among German institutions, which appear to be sitting back and waiting for clues about broad market direction before making any radical changes to their current, conservative investment approaches.

According to the results of Greenwich Associates’ 2010 German Investment Management Study, German institutions reported solid growth of 9.2% in assets under management from 2009 to 2010. And this growth is based largely on the steady appreciation of asset values. However, the shifting composition of institutional portfolios reveals the extent to which German institutions are emphasizing de-risking over alpha generation: Over a period of historically strong performance in the DAX Index, institutional equity allocations in Germany increased by less than 1%.

“For German institutions, risk management imperatives are trumping any desires to seek out performance,” observes Greenwich Associates consultant Tobias Miarka. The 227 large German institutions participating in Greenwich Associates’ 2010 Investment Management Study clearly communicated that safety, stability, and conservatism were their top priorities this year.

In conclusion, it is the investor’s risk appetite that will decide if alpha-generating strategies should be emphasized. After all, it will be a shame to let the stock market run away without a good fight. But let it be at the back of every investor’s mind that higher profit potential always comes with higher risks. This risk/return trade-off should be matched against the undertaking of only market risk (as in the case of German institutions) to see if the result is worth the effort. In any case, the investor is well advised to read each fund factsheet carefully to decide if the fund has embedded derivatives. It is all too common for investors to ‘take for granted’ that all retail funds are ‘long only’. It is better to hold dearly to the maxim of caveat emptor than the duty of good faith.

Currently a communications specialist, Andy has also spent 15 years in banking & finance dealing with derivatives, FX, Equities, and Wealth Management. He is a Certified Financial Planner (CFP) and holds an MBA from South Australia. Andrew also has a professional diploma in banking & finance from the Institute of Banking & Finance.

Please click here for more information about this author.

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