Portable Alpha:

Process, Cost and Risk
Mark Carhart, GSAM

On October 27, senior executives met for a discussion of the portable alpha investment strategy at Alpha’s offices in New York. Participating were Mark Carhart, managing director, co-chief investment officer and co-head of Quantitative Strategies, Goldman Sachs Asset Management; Kent Clark, chief investment officer and co-head of Hedge Fund Strategies, Goldman Sachs Asset Management; Joseph Gieger, managing director, GAM; Jim Haskel, director-portfolio strategy, Bridgewater Associates; Yoshiki Ohmura, head of portable alpha strategies, GAM; and Bob Prince, co-chief investment officer, Bridgewater Associates. Marilen Cawad, news editor of Special Projects for Alpha served as moderator.
Kent Clark, GSAM

Moderator: What is portable alpha and how is it different from hedge funds and traditional active management? Kent Clark, Goldman Sachs Asset Management: Portable alpha is very straightforward. The idea is to take the active risk and return that is generated by an active manager, and move it from whatever asset class or field of expertise the manager has onto the benchmark of choice. There is not a lot of difference between portable alpha and hedge funds and traditional active management. Each manager has a single set of views that lead to a single optimal portfolio. The question is where an investor wants that set of views, and that alpha, placed. If it’s in a traditional active management context, then you have constraints, for example on asset classes, benchmark membership, and short selling. Take the same views and put them into a hedge fund context and they are unconstrained. The benefit of portable alpha is that it takes unconstrained positions resulting from the manager’s views and overlays them with a benchmark of choice. Joseph Gieger, GAM: It's simply a technique where someone can enhance the returns above and beyond the index of choice. If a client were to look toward a Lehman Aggregate bond index or an S&P 500 equity index, he would be able to assure himself of at least the return of that particular index. Above and beyond that, he's looking to add additional uncorrelated return to that benchmark, which we call alpha. He would then couple or port that return with the index of choice and thereby create a portable alpha solution. Bob Prince, Bridgewater Associates: Different people use language differently. The way we think about it is that there's alpha overlay, there are hedge funds, and then there's traditional

management. All three of those can be portable. In other words, the portable part is the action that you take to engineer the portfolio: to take a given alpha and reposition it someplace else. Alpha overlay is one form of portable alpha. It is the process of literally creating an alpha from scratch, disassociated from any underlying assets. Moderator: Is there an investment size requirement to do portable alpha? Mark Carhart, Goldman Sachs Asset Management: Many managers have created portable alpha vehicles benchmarked to the most common asset classes and the minimum investment sizes are small. But to do a more complex, customized portable alpha program, you have to think about an investment portfolio that is larger, in the order of hundreds of millions of dollars or more. Moderator: How would you describe the growth in portable alpha? Gieger: We continue to see strong demand from institutional clients. Primarily driving it is the fact that they can keep their existing asset allocation, i.e., X percent in equities, Y percent in bonds, intact while at the same time adding a return from funds of hedge funds above and beyond what traditional approaches are able to offer. This simplicity, that is not having to change your overall asset allocation, has contributed to portable alpha’s attractiveness and growth. Clark: For many investors, taking alpha and beta separately as risk sources and return sources is still a relatively new concept. If you look at a typical asset allocation for an institution, even if every dollar allocated from that institution is

Joseph Gieger, GAM

Jim Haskel Bridgewater Associates

Yoshiki Ohmura, GAM

This Sponsored Roundtable was prepared by the Special Projects Department of Alpha

Bob Prince Bridgewater Associates
Alpha Sponsored Roundtable • November/December 2006 • 1


actively managed in a traditional way, the lion’s share of the risk comes, first of all, from passive equity exposure, secondly, from passive fixed income exposure, and then just a small part of the overall risk budget is from alpha sources. So there's huge room to increase the amount of alpha, and portable alpha is one way of essentially having your beta cake and eating the alpha, too. Moderator: What’s the difference between bundled and unbundled solutions? Yoshiki Ohmura, GAM: When we speak of bundled solutions, we are primarily referring to a fund or other legal structure that multiple clients can invest in and is typically managed by one manager. It could also be a bank-issued security where all the assets of those clients are managed on a commingled basis by the manager. In unbundled solutions, clients are running the alpha and beta overlays individually on their own balance sheets, usually using two separate managers. Moderator: Which solution is better suited for institutional clients? Ohmura: We think that most clients are better suited in a bundled solution. The big advantage is that it's a one-line item accounting entry. Additionally, the product provider manages the operational and legal aspects of the derivatives portfolio, making it very easy for clients to handle. At the same time, there is leverage in portable alpha. So in a bundled solution, that leverage is non-recourse, i.e., the client’s losses are limited to what they invested in that legal structure. Whereas, if they are running an unbundled solution, not only is there risk on the amount invested in the alpha source, but at the same time, the client is fully liable on the derivatives portfolio. Jim Haskel, Bridgewater Associates: It's important to note that right now there are some big institutional pension funds that are actually organizing themselves around the unbundled principle. For example, there are two big pension funds in Europe, one in Denmark and one in Holland, that are organized now with a beta department and an alpha department, which seems to us to be the right way to go about it. That started in Europe, and I know they’re starting that here in the US. And once you get to that point, then you truly are in an unbundled world, and it seems to

Joseph Gieger, GAM: “We continue to see strong demand from institutional clients.”
me a better world than what we're currently in now where we're trying to fit things in order to get the advantages of breaking apart alpha and beta, but doing it in a sort of a chaotic way where it's the equity department, the fixed income department over a bond or an equity benchmark. Carhart: One of the advantages of portable alpha is that you aren’t compelled to take as much beta risk as you would in a traditional product. Therefore, there’s the opportunity to produce investment products with higher Sharpe ratios by shifting risk from beta to alpha because the return per unit of risk on beta is a lot lower than a good alpha source. We're seeing many clients ask us as asset managers to take a stand on the proportion between beta and alpha and even choices of strategies within an aggregate beta and alpha portfolio. So it’s all about looking for an optimal, maximum, Sharpe ratio portfolio. Moderator: What are the key considerations in selecting the alpha and beta components? Prince: When we look at any portfolio, we break it down into three parts. You’ve got the risk-free rate; the beta, which is the return that's derived from systematic risk; and alpha, which is the return over and above the beta that's generated by manager skill. The fundamental difference between beta and alpha is that everybody in the world could invest in a certain type of asset, and everybody in the world could earn that excess return from the risk premium. But alpha is a zero sum game. So if everybody in the world is doing alpha, on average they all break even, minus transaction costs. With beta, you can be more confident that if you wait long enough, you will outperform the risk-free rate. With alpha, you never know if you will. Whether you produce returns from alpha is entirely the function of your own ability to either make market bets or pick people who know how to make market bets. Carhart: We think that attractive alpha strategies should have the following features, which we refer to as the 5 C’s: high consistency; low correlation; capacity to sustain the high information ratio; capital efficiency; and low implementation costs. Consistency means how high the return is per unit of risk, typically measured in the information ratio of the strategy. Correlation refers to how the strategy relates to your existing portfolio. Capacity is fairly

Bob Prince, Bridgewater Associates: “Whether you produce returns from alpha is entirely the function of your own ability.”
2 • Alpha Sponsored Roundtable • November/December 2006


Just as sailors must know the fine points of navigating through both smooth and rough waters, asset managers must understand the complexities of the investment business. At Goldman Sachs Asset Management, a skilled group of professionals with technical acumen and deep experience offer products across a broad range of asset classes, including equities, fixed income, currency, hedge funds, private equity and real estate. With a commitment to excellence for the ultimate benefit of our clients, we focus on providing consistent results and outstanding service across every interaction.

To learn more about our portable alpha solutions, contact: Suzanne Escousse at suzanne.escousse@gs.com

Quoted from Bowditch, Nathaniel. The American Practical Navigator. Celestaire and Paradise Cay Publications, 2002. Chapter 1. ISBN 09339827544 © Goldman, Sachs & Co., 2006. All rights reserved. 06-4446


obvious, since many high information ratio strategies have relatively small investment sizes, limiting the impact on your portfolio. Capital efficiency is not as well appreciated and refers to how many dollars of alpha are achieved per dollar contributed to the strategy. Clients with a large indexed allocation might not care as much about capital efficiency, but most investors are much more capital constrained than risk constrained. And finally costs, which include not only management fees but also implementation costs, which can be significant in less liquid strategies. You can essentially rank strategies on these 5 C's to come up with the ones that are most attractive for each investor. Haskel: The problem is that there are not a lot of managers who actually do that very well. And those managers who do that very well tend to be at capacity. At the end of the day, alpha is about skill. When I talk to clients about what they expect from their active management, it's notoriously high information ratios across the board. Of course, they wouldn't say it's low information ratios because otherwise what's the use of having alpha in your portfolio? But about half of them are going be right and half are going be wrong. So having that confidence in the five C's is good, but that confidence should be humbled a little bit. Ohmura: In terms of risk and volatility, there is usually a lot more risk in the beta component than in the alpha piece. So if you get that piece wrong from the structural side, you could do a lot more damage to your product than the alpha side could compensate for. When building a portable alpha solution, one has to be very cognizant about the characteristics of each individual component, how those individual pieces are managed and how they work together. There are many different ways of implementing portable alpha and a lot of investors are not spending enough time looking underneath the hood to see for themselves how the actual solutions work. Haskel: The reality of it is that there are a lot of efficiency gains you can get in beta that aren't yet being taken advantage of, through leveraging types of techniques that equalize risk and return of asset classes and create more diversified asset allocations that are currently equity dominated. Those haven't yet been pushed by the whole industry, in part, because either they haven't thought about it or, more importantly, they have been focused on where the highest fees are, which is alpha.

Jim Haskel, Bridgewater Associates: “I see a world in which fees are going to be much more discriminating.”
Prince: Alpha overlay managers and hedge funds have structural advantages over traditional alpha generators. They have a greater breadth of choices; they can go long and short. They can have more latitude to create more diversification in the portfolio, and with more diversification they can produce more consistent returns. As a result, they have been more successful at producing alpha than traditional managers. Their fees are higher but if traditional managers are generating negative alpha and charging fees for it, that's actually a lot higher fee than a manager who's producing a positive alpha and charging a portion of that. Haskel: As tools become available, investors can look through their hedge funds and absolute return strategies, and identify which ones are truly offering alpha beyond either cash or any embedded beta and are uncorrelated. I see a world in which fees are going to be much more discriminating, where those types of managers are going get the highest fees and the ones that aren't providing any value are no longer going to be able to charge those fees because they'll be spotted out. Moderator: Why is portable alpha an attractive strategy now? Carhart: People want to get more alpha into their portfolio. They also want to have the right betas in their portfolio and the right combination of alpha and beta. Another reason is the significant growth of the derivatives market. In order to transport the alpha, you need to access derivative instruments that require small amounts of initial capital to obtain larger exposures and are also liquid enough to easily adjust the beta. Ohmura: In general, institutional investors’ behavior can be attributed to circumstance. Currently many pension funds are underfunded, so a solution offering potential outperformance over the traditional asset allocation approach can be very appealing. This is similar to the recent increase in liability driven investing (LDI) popularity. In certain countries such as the UK and the Netherlands, regulation changed recently, requiring pension funds to mark liabilities to market. So even though there hasn’t been a change in their liability structure, the change in regulation has been the catalyst for the change in how those liabilities are managed.

Mark Carhart, GSAM: “It’s all about looking for an optimal, maximum, Sharpe ratio portfolio.”
4 • Alpha Sponsored Roundtable • November/December 2006

Moderator: What are the risks associated with managing portable alpha?

Bridgewater White Paper

Alpha Sponsored Statement • November/December 2006


Ohmura: When we're implementing portable alpha strategies, we’re replicating the beta through a derivatives market. That could be forwards, futures, swaps, even options, and the alpha pieces are simply a direct investment in a portfolio of hedge funds or in a fund of hedge funds. Just from that framework, there's inherent leverage in the strategy, so the major risk is the correlation between the alpha and the index that the beta portfolio is replicating. Prince: I think that an alpha overlay, or portable alpha strategy, inherently has huge advantages in terms of risk control simply because you have the ability to diversify so much more. You can bring so many different types of alpha that are uncorrelated into the portfolio that your exposure to any one of those types of alpha is substantially reduced. That's the big headline. The sub-headline is that if you don't do it right, you can mess it up. For example, some people are drawn to certain apparent alphas that have a certain amount of observed risk that's then leveraged up, but there’s a lot more actual risk than is apparent in the historical returns. Any kind of strategy that's essentially a selling of options, like earning a credit spread, mortgage spread or any kind of a short options position has an appeal because it produces a dime of profits every quarter with a relative degree of consistency, but offers a dollar of risk that is not observable in the data. Clark: One risk in a portable alpha strategy is not acknowledging that there could be structural beta or some short-term conditional beta included in the alpha portfolio. So you can find yourself with more or less beta in your overall portable alpha strategy than was originally anticipated. Moderator: What resources are required for a client to run a portable alpha program with hedge funds as the alpha source? Ohmura: It really depends on the type of solutions clients are looking for. With a bundled solution, clients are not required to have any extra resources. It's just like buying a fund. For investors who are going for the unbundled solution, where alpha and beta are run independently of each other, they would need the operational and risk management resources required to deal with over-the-counter derivatives or a futures

Kent Clark, GSAM: “If you can find real alpha, then it’s a matter of engineering beta into it.”
contracts as well as substantial legal capacities for negotiating and executing various agreements that are required. That can be quite substantial, especially for an institutional client who is not active in the derivatives market yet. Clark: The reason we're talking about portable alpha is that there may be institutional or intellectual constraints around the whole idea of going all the way to pure alpha strategies, away from beta. One of the conveniences of having the portable alpha and beta done by someone else in a package is that then you can use many of the same evaluation tools with your portable alpha provider that you used before in traditional asset classes and traditional active management. The hardest part is finding the alpha. If you can find real alpha, then it’s a matter of engineering beta into it – being very careful about counterparty risk, and being very careful that you evaluate if there is beta embedded in your alpha source or not. Moderator: What should investors look for in a portable alpha provider? Gieger: Investors should look for a solution that's going to fit their needs. Whether it's about generating a return in excess of a particular benchmark or mitigating other risks within the portfolio, that's what they should be targeting. They should also look for a provider that they can understand. They shouldn't go blindly into strategies that are not fully transparent, not easy to use, and do not offer a complimentary risk return profile to their benchmark or beta of choice. Clark: If there's no alpha, then you don't want to take it anywhere. So first, find the alpha and then find the resources inhouse or with that alpha provider to efficiently and effectively execute your beta part. Prince: You have to find a provider who can beat the markets. You want a positive expected return that is uncorrelated to your other alphas and betas. You want a great risk control process within that alpha, particularly with respect to event risk. You want back-office operations that are well run. And then, you want to see the ability to engineer, expand and shrink the risk, combine it with different things, and customize as necessary. ■

Yoshiki Ohmura, GAM: “There is usually a lot more risk in the beta component than in the alpha piece.”
6 • Alpha Sponsored Roundtable • November/December 2006

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