Another "Can't Miss" Investment Strategy That Missed

The massive losses across the financial markets have exposed the flaws behind many of the esoteric strategies with unrealistic promises created by the wizards of wall street. One of these was the "portable alpha" strategy. I teach a course in an MBA program for non profits in which we did a Harvard Business School case about an endowment using this "strategy" and even these students who had limited background in finance viewed this strategy with skepticism (with much encouragement from me)

The strategy draws its name from the purported ability to capture alpha (the excess return over the market index) regardless of market risk. For example one could go short the s+p 500 index with futures and then use the cash to invest with a manager who would generate alpha (excess return over the s+P 500) Since the short position in the s+p 500 offsets the market risk in the alpha manager's portfolio, the strategy has separated out the exposure to the manager's skill (alpha) from the market risk. And since the manager has such great skill we are told, this offers the opportunity to generate returns from the stock market regardless as to what the market does. (yes it is hard to believe but $billions were invested based on this pitch)

What could go wrong ? As my students 7 weeks into their first investment class figured out: the investment manager could fail to generate alpha and his underperformance relative to the market would mean the strategy would lose money.
Stripped of all the marketing material and jargon the strategy is just one big leveraged bet that the genius manager you give money to will generate above market returns with below market risk....in other words they will turn lead into gold.


Apparently the investment officers at several pension funds and endowments underestimated this risk as the wsj reported yesterday (my bolds, my comments in italics)
And as is always the case it seems Wall Street collected its fees and taxpayers will make up for the lack of fiduciary responsibility by public employees .

'Alpha' Bets Turn Sour
Pennsylvania Pension Now Faces Billions in Losses
By RANDALL SMITH



The stock-market downturn could force the Pennsylvania state employees' pension fund to make cash payments of $2.5 billion or more to trading partners on Wall Street.

The potential hit to the $27 billion pension fund is the result of an exotic strategy used to help finance $9.2 billion in hedge-fund investments. Those bets helped the pension fund beat the market when stocks were rising, but backfired when the market sank.

Use of the aggressive strategy, called "portable alpha," has been cut in half, with officials of the Pennsylvania State Employees Retirement System acknowledging that the pension fund's exposure was "too large." (now there's an understatement)

Since stocks began falling, the fund has had to pay out $1.5 billion. Based on current market values of derivatives still outstanding, Pennsylvania could owe another $1 billion, a fund spokesman says. With the pension fund down about 14% in the first nine months of 2008, it is possible that the state will have to quadruple its annual contribution to roughly $1 billion in 2012, according to people familiar with the situation.

The blowup is yet another example of the wide-ranging damage caused by sophisticated investment strategies peddled to pension funds and other institutional investors when the stock market was soaring.

An estimated $75 billion or more has been invested using portable alpha. Other pension funds that used the strategy include the San Diego County Employees Retirement Association, with $8.1 billion in total assets, and funds in Kansas, Massachusetts and South Carolina.

Sean Mathis, a partner at business-valuation firm Mathis & Co., believes some pension funds were pulled into portable alpha programs without fully realizing the risk. "(another major understatement) When all the hand-waving is done, what investors ended up with is a highly leveraged bet on the market and a slug of money in hedge funds," he said.

Barring a turnaround, pension funds and other devotees of portable alpha "may find out that all they've done is paid a lot of fees and maybe lost a lot of money to boot," Mr. Mathis adds.

The idea behind portable alpha is that it's easy to match the market. If you do it using derivatives like futures, you can tie up less cash and get the same return you would using an index fund. Then you can use the rest of your cash to beat the market. The strategy gets its name from the ability to generate alpha, or above-market returns. As long as the returns on the remainder of your cash beat the futures' cost, you outperform the market. Typically, investors turned to hedge funds that are supposed to beat the market in good times and bad to invest that cash.

Last year, Pennsylvania pension-fund officials said the strategy would pay off as long as returns on the hedge-fund investments topped the interest rate owed on the investments. That is what happened when the market was rising. From 2003 to 2006, the pension fund's U.S. stock assets beat the market by an annual average of 6.2 percentage points.

But this year, the portable alpha portion of their portfolio, worth about $6.4 billion at the start of the year, is trailing the market by an estimated 15 percentage points, indicating that with U.S. and world markets down by 41%, they have lost more than 55% of their value. Fund officials say that, even with that setback, the strategy has generated $500 million in cumulative above-market returns.

Pennsylvania's portable-alpha strategy was put into place by the fund's former chief investment officer, Peter Gilbert, who built the program over a decade but stepped down in mid-2007 to become chief of the Lehigh University endowment. A Lehigh spokesman said Mr. Gilbert declined to comment.( I wonder why)

Pennsylvania invested more in hedge funds than any other state pension fund. Those hedge funds returned 2.8% for the year ended in June, but their performance turned negative in the third quarter and has remained so thus far in the fourth quarter, according to a spokesman for the pension fund.

Pennsylvania spokesman Robert Gentzel says the pension fund has had to sell liquid assets to make cash payouts on swaps it used to implement the strategy, but that such sales weren't unexpected. Assets had been set aside as collateral for the swaps, he adds. Portable alpha was pioneered in the mid- to late 1980s at Pacific Investment Management Co., led by famed bond manager William Gross, and by corporate pension-fund manager Marvin Damsma at Amoco Oil Co., according to the book "Capital Ideas Evolving" by Peter Bernstein.

(Not content to peddle this stuff to "sophisticated" institutional investors it seems individuals had the "opportunity " to access the strategy as well:)

A Pimco stock mutual fund using portable alpha has trailed the market by more than 10 percentage points this year. A spokesman for Pimco, a unit of German insurer Allianz SE, which has $1.5 billion in mutual funds using the strategy and another $30 billion for institutional investors, declined to comment.

Other bond managers with funds that used portable alpha to boost returns also have suffered. Among them is the Western Asset Management unit of Legg Mason Inc. Assets in the unit's $5 billion U.S. Index Plus accounts were invested mostly in mortgage, asset-backed and corporate securities, which have been clobbered amid the market's meltdown.

"I think this particular strategy is going to be pretty widely discussed, debated and re-evaluated," (a(and either tossed in the trash bin or "improved and remarketed "in a couple years three guesses which will happen) says Jim Hirschmann, chief executive of Western Asset Management.