Portable Alpha at Dutch Pension Funds, Quo Vadis?

An assessment of its application, impact and relevance

by Tom Oor 2007

Master’s Dissertation Dissertation submitted in accordance with the rules of TiasNimbas Business School in partial fulfilment of the requirements for the degree of MSc in Financial Management

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September 2007 Student name: Student ID: Degree: Dissertation Title: Tom Oor 200652026 Master by Advanced Study Portable Alpha at Dutch Pension Funds, Quo Vadis? An assessment of its application, impact and relevance Student Agreement

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IV Tom Oor © 2007 . Furthermore. impact and relevance Keywords Portable Alpha Market Inefficiencies Portfolio Investment Abstract This dissertation examines the relevance of portable alpha for Dutch pension funds. Subsequently. interviews were held with a mixture of eminent practitioners and academics to provide empirical evidence. Alpha Investing Dutch Pension Funds Overlay strategies portfolio optimization Alpha Asset Allocation strategy The extensive literature review grounded the concept in a solid academic framework and exhibited the boundaries of relevance for the concept. the aim is to reveal the inherent limitations of the concept and to expose the hurdles to manage and monitor the concept. The research revealed that portable alpha in contrast to the conventional approach is a valuable contribution by allowing for separating alpha and beta decisions in which the alpha and beta portfolio can be optimized for their distinct means. Quo Vadis? An assessment of its application.KEYWORDS AND ABSTRACT Name: Tom Oor Title: Portable Alpha at Dutch Pension Funds. Nevertheless. Subsequently. dissimilar pension fund organisational capabilities revealed that portable alpha is not (yet) suitable for all pension funds. the difficulties for applying the concept in an organisational context and the dissimilar relevance for individual pension funds. portable alpha has limitations having to exclude alpha sources and the difficulties to manage and monitor such a complex process. The research’s principal purpose is to define the boundaries of relevance for the concept in general and in a Dutch context. The results from the literature reviews were used to form a rudimentary idea of the broader concepts forming the concept and attempted to avoid projecting the author’s thoughts upon the interviewees.

Larry Siegel and Mr. No dissertation is solely the effort of the author and this dissertation is certainly no exception. Rob Arnott for sending me their publications. I directed my efforts to search for an actual investment issue at Dutch pension funds. Last but not least. Also. I arrived at portable alpha. in combination with being the son of an actuary and thus exposed to long diner discussions about developments at Dutch pension funds. peculiarly the concept was devoid of an extensive academic body of literature and the predominant focus was on explaining the function of portable alpha. This dichotomy aroused the interest to examine the stance of portable alpha amongst Dutch pension funds and the relevance for them. Tom Oor Utrecht. However. I am thankful to my supervisor guiding the advancement of my dissertation in hopefully the proper direction and providing adequate support. 8 September 2007 V Tom Oor © 2007 . I am grateful to all those whom assisted me in the culmination of my last academic year in the form of this dissertation.PREFACE Fascinated by the intricate investment environment in which Dutch pension funds have to operate. I would like to express my gratitude for the willingness of the interviewees to participate in my dissertation and share their viewpoints on portable alpha and investment practices. I sincerely appreciated the gesture of Mr. The notion portable alpha appeared to be a well debated issue at the investment industry. Furthermore. After a long quest of searching a subject that would justify a real knowledge gap in terms of academic knowledge and that moreover would be the crowning glory of my last academic year. In particularly to my father for his ability to clarify hot-debated pension fund issues and without whose help selecting appropriate interviewees would have been almost an impossible task.

I devote this dissertation to my grandparents. for their eternal support and understanding VI Tom Oor © 2007 .

TABLE OF CONTENTS (Condensed) Keywords and abstract Preface Table of contents (condensed) Table of contents List of figures IV V VII VIII XII Part I – Introduction 1 Overture 2 Research methodology 1 2 8 Part II – Literature Review 16 3 The underlying creed 4 Active management: the quest for alpha 5 Portable Alpha 17 23 35 Part III – Research Analysis 48 6 Analysis of the in-depth interviews 7 Findings and discussions 8 Conclusions and recommendations 49 65 72 Appendices References 77 107 VII Tom Oor © 2007 .

2.9. Dissertation structure 2. Research Methodology 2. Reliability 2. Construct Validity 2.7. Analytical progression 2. Scope Literature Review 2.The Literature Review 1 2 2 4 5 5 5 6 6 8 9 9 10 11 11 12 12 12 13 13 14 14 15 15 16 VIII Tom Oor © 2007 . Elite Interviews 2. The Soundness of the Research 2. Research Approach 2. Research Contribution 1.6. Aim 1.3. The Initial Conceptual Framework 2.9.1. Research Philosophy 2. External Validity Part II . Research Strategy 2. Background 1. Overture OF CONTENTS Keywords and abstract Preface Table of contents (condensed) Table of contents List of figures IV V VII VIII XII Part I . Primary Research 2. Research Objectives 1.1. Interview Structure 2.7.5. Research Purpose 2. Research Question 1.5.2.Introduction 1.7.

6.2.1. The (Human) Skill Factor 4. Portable Alpha Management: The Operational Procedures 5.6. An Optimal Alpha Source 5. Scepticism towards “New” Investment Products and Strategies 6.1. Alpha Returns: The Alpha Universe 4. The Benchmark 4. The State of Market Efficiency 3.2.1. Portable Alpha in a Contemporary Context Part III Research Analysis 6.1. The Concept 5. Portable Alpha 5.5.2. The Portable Alpha Extent 5. The Domain of Active Investing 4.7.5. Portable Alpha at the Dutch Pension Funds Conclusions 4. A Radical Change in Mindset Tom Oor © 2007 . Restriction to Alpha Sources 5.The Conceptualization in Depth 5. Analysis of the In-depth Interviews Measuring Investment Performance 4. Markowitz 3.8. Market Risk and Active Risk: Unconditional Rewards and Conditional Rewards 4.10. Derivative overlay: The Inherent Difficulties 5. Active Management: The Quest for Alpha 4.4. The Value Addition of Alpha 17 17 18 21 22 23 23 24 26 27 29 30 31 32 32 34 35 35 36 40 40 41 42 44 45 45 46 49 50 50 52 52 IX 5. The cost of the Quest for Alpha Alpha Performance Constraints 4.1.3. Derivative Overlay: Alpha Decomposition Building active portfolios: Maximizing Alpha Returns 4. The Portable Alpha Approach versus the Traditional Approach 5. The Underlying Creed 3. The Capital Asset Pricing Model 3. Conceptual Findings 6. The relevance of portable alpha is found in the contribution of alpha to pension fund portfolio returns 7. Alpha Investing at Dutch Pension Funds 6.3. The applicability of portable alpha depends upon the organizational context of a pension fund 8.2. Portable Alpha: A Portfolio Division in Alpha and Beta Portfolios 6. Findings and Discussions 7. The Sustainability of Alpha 6.3.4. Non-Conventional Asset Categories Recommendations for Further Research 8. The Conceptual Framework: Relating the Variables 7. The Portable Alpha Manager 6.6.Dissertation Proposal Appendix II . Difficult to Manage Portable Alpha 6.Profiles Interviewees Appendix 3 .6.1.2. The Asset Allocation Argument: Decoupling Alpha and Beta 6. The Relevance of Alpha: The Situational Context of Portable Alpha 6. Consensus on the relevance of portable alpha remains unattained 7. Portable Alpha Remains Subject to Classic Alpha Investing Difficulties 57 The Alpha Contribution to Portfolio Returns 53 53 54 54 55 6. Practical limitations to the theoretical concept have been identified 67 69 57 58 58 58 60 61 65 65 7. The Research Process in Retrospect Appendices Appendix I . Conclusions 8.1.Elite in-depth interview results 71 72 72 75 75 77 78 93 94 References 107 X Tom Oor © 2007 . Conclusions and Recommendations 8.

2.1 The real impact of aggregating alpha and beta risk Exhibit 4.1 The Alpha Continuum Exhibit 6.2 Alpha and beta risk aggregation under similar risk aversions Exhibit 4.7 The conceptual Framework XI Tom Oor © 2007 .2.LIST OF FIGURES Exhibit 2.2.9 Exhibit 5.2 Methodology Structure Initial conceptual Framework The Capital Asset Pricing Model 8 9 18 20 25 26 33 36 37 38 40 56 64 Exhibit 3.2 Efficient Frontier of Alpha Managers The portable alpha concept Conventional portfolio approach Exhibit 5.1 Exhibit 5.2 Exhibit 3.1 portable alpha approach Exhibit 5.1 Exhibit 2.1 Graphic display of alpha performance Exhibit The Contribution of Alpha to portfolio investment Exhibit 6.

the aim and scope of the dissertation. 1 Tom Oor © 2007 . in chapter 2 the research methodology in descending order flowing from the general to the specific is being discussed.Part I Introduction Part I functions as an introduction to the dissertation. Chapter 1 elaborates on the rationale for undertaking the research. Subsequently.

However. OVERTURE This first chapter serves as a synopsis of the dissertation. First the background of the dissertation is dealt with to provide the rationale and justification for undertaking the research. the dissertation structure is clarified serving as a guideline for the reader. Thereby it provides the ability to decouple alpha and beta resulting in the ability to optimize alpha for incremental returns and beta for asset-liability matching. the proliferation of conferences on portable alpha. Within this context.1. the scope of the research is displayed and lastly. new investment concepts emerge and submerge attempting to enhance portfolio investment performance. 1. the aim. The dissertation and the underlying rationales for undertaking the research are founded upon a line of reasoning that has practical as well academic significance. Background Modern thinking about the domain of investment is largely influenced by the invaluable grand theories of Markowitz (1952). especially pension funds. Implementing a portable alpha concept might lead to optimizing alpha returns in portfolio context and the ability to provide a matching portfolio and a return portfolio. portable alpha is appealing as a valuable concept for portfolio investment by institutional investors. Sharpe (1964) and Fama (1970) that revolutionized the world of investments. First.1. Their respective theories form the foundation for our assumptions and perceptions of the world of investments. Hereafter. Portable alpha is one of such contemporary arising conceptualizations. Therefore. It attempts to enhance portfolio investment by adding low correlated sources of return (Alpha) to a portfolio whilst maintaining the combined portfolio’s desired systematic (Beta) exposure (Coates and Baumgartner 2006). Based upon these rationales. objectives and central question of the research are specified. the myriad of publications and the large number of consulting firms offering services around portable alpha serve as a testimony for the traction it has gained amongst business practices. a 2 Tom Oor © 2007 . portable alpha might enhance portfolio performance in the aforementioned ways. Theoretically speaking.

Fung and Hsieh (2004) discuss the conduciveness of long/short hedge funds as a source of extracting alpha for portable alpha. Academics have forayed into the field of portable alpha but academic research related to the subject remains in its infancy.consensus about the relevance of portable alphas has not yet been attained. Recent developments in Dutch accounting rules and regulatory requirements have further narrowed down the scope for risk tolerance and investment possibilities. Business practices and their stances on portable alpha are roughly subdivided into two camps: the sceptics questioning the elusiveness of alpha itself and those who are beholding an incremental implementation amongst institutional investors. Hence. Thirdly. Levy (1999) and Kung and Pullman (2004) are one of the rare few who discuss the processes. is not substantiated by an extensive body of academic research. Nonetheless harmonizing liabilities with fixed income or index linked bonds reduce exposure to interest rates and inflation but do not yield the returns to pay pensions. nevertheless tend to remain on the surface. portable alpha has gained momentum amongst institutional investors due to its appealing features of providing leeway to asset allocation whilst generating alpha from the panoply of different alpha resources. 3 Tom Oor © 2007 . it would be worthwhile to investigate whether portable alpha contributes to such an intricate investment environment. Secondly. and thus supporting the relevance of the concept. The interest the concept has gained amongst business practices and the lack of substantial academic literature could either be due to unilateral development of the concept and thus a lack of interaction between academics and practitioners or academic research still has to pick up on the concept. Arnott (2002) makes a valuable contribution by manifesting how portable alpha allows for the risk budget to be most effectively optimized and alpha be maximized. much of the work to date is targeted at a practitioner audience and though intuitively appealing. benefits and drawbacks of Portable Alpha. Portable alpha has become the panacea for adhering to these stringent accounting and regulatory rules and narrowing down the mismatch between assets and obligations and the ability to provide incremental returns. vetting the notion of portable alpha. OECD 2005). These phenomena have forced pension funds to embrace liability driven investment (LDI) by investing in financial assets that match their liabilities (Pensioen en Verzekeringskamer 2004.

By doing so. Aim The fundamental aim of the dissertation is to shed light on the relevance of portable alpha for investment policies at Dutch pension funds. the Netherlands with its well developed pension fund infrastructure and strict legislative framework is an interesting setting to explore the relevance of portable alpha. A sub aim is to reveal the differences between the theoretical concept and practical implications. Dutch pension funds have the largest relative amount of assets in terms of Gross Domestic Product (GDP) under management (OECD 2005). it attempts to vet the concept through a rigorous academic framework and explore until which extent the theoretical conceptualizations of portable alpha add value to investment policies at Dutch pension funds. funding policies and investment policies. Ultimately. Furthermore. The complexities inherent to portable alpha might impose difficulties upon the management and monitoring of the concept. Vetting portable alpha and the relevance might lead to an enhancement in investment performance.Fourthly. In the Netherlands such as a contribution would translate immediately into economic development as the pension system applies to the entire population. 4 Tom Oor © 2007 . The attempt here is to demonstrate the limitations from an organisational point of perspective to embrace the concept. The industry has a large sample of pension funds differing in size of asset under management. The combination of these factors influencing the sample is purposeful for analysing portable alpha from a wider perspective.2. the Netherlands includes a large segment of large pension funds which are probable to operate at the frontiers of knowledge and thus capable to provide empirical evidence to portable alpha. 1.

Pension funds. 1. The sample for collecting empirical evidence is limited to Dutch pension funds subject to the Dutch regulatory framework. empirical data focuses solely on industry experts located domestically. particularities. Research Question “What is the relevance of portable alpha for the large Dutch pension funds?” 1.5. Therefore Dutch pension funds that have moved to nations in the European Union with a less stringent regulatory framework are excluded. the focus is principally on qualitative information and quantative information serves a secondary illustrative purpose. Scope A dissertation can’t impossibly be exhaustive. practitioners and academics. difficulties and usages of portable alpha from the viewpoint of investment consultants. therefore the scope for the research has been limited allowing for focus. • To examine what the impact of portable alpha is on conventional portfolio investment management at Dutch pension funds.1. Research Objectives The research question functions as the central guideline for the research and is subdivided into research objectives to concretize and provide support for the central question. Furthermore.4. • To reveal the relevance of portable alpha in an organisational context at Dutch pension funds. 5 Tom Oor © 2007 . • To explore the extent to which portable alpha might contribute to enhance Dutch pension fund investments. The following research objectives are pursued: • To investigate the implications.3. might obtain advice about their investment policies from foreign advisors. in particularly the ones having larger amounts of assets under management.

Chapter 7 synthesizes the findings from the literature review with the results obtained in the empirical research. The academic value is added by demonstrating how the applied concept of portable alpha. Pension funds contemplating more advanced investment strategies have an objective insight in the relevance of the concept and are thus more able to discharge fallacies or false claims by the investment industry. Part III focus on the analysis of the research commencing in chapter 6 with displaying the results obtained in the interviews.6. Secondly. Chapter 2 defines the research methodology and the reasons behind opting for the particular methodology. relates to the financial economic theories. advancing to chapter 4 exploring the particularities of the domain of active investing and ultimately arriving at chapter 5 in which the impact. 1. Thus. Lastly. the research interweaves portable alpha in an academic framework and appends knowledge to the existing academic body of knowledge on portable alpha. by exposing the obstacles of the concept in organisational context pension funds can weigh in mind if their pension fund is subject to these limitations and if a portable alpha strategy is worthwhile in comparison to their actual investment policy.7. relevance and limitations of portable alpha is discussed. Part II encompasses the literature review exposed as a narrative advancing from the abstract to the specific commencing in chapter 3 with the cornerstones of modern finance. emerging from the practitioners’ field of finance and investment. Dissertation Structure The dissertation is structured according three parts which are subdivided into chapters.1. Subsequently. Firstly. Furthermore. Part I introduces the aim of the dissertation and the rationale for undertaking the dissertation. This in contrast to the current academic evidence on portable alpha that predominantly remains in the explanatory phase grounds the conceptualization and demonstrates the boundaries of relevance. Chapter 8 6 Tom Oor © 2007 . Research Contribution The contribution of the dissertation is bivalent and therefore has as well academic value as value for practitioners.

finalizes the dissertation by drawing conclusions based upon the synthesis in the attempt to answer the central question of the dissertation. 7 Tom Oor © 2007 .

• Secondly.1. to describe the methodological approach chosen and the resulting research design. 8 Tom Oor © 2007 . • Fourthly. to demonstrate how the results from the research strategy will be transformed from raw data through the process of abstraction to the concluding theory. • Thirdly.Methodology Structure The aim of this chapter is fourfold: (author) • Firstly.2.1). These stages are all interlinked and proceed in a descending order of abstraction (see exhibit 2. Research purpose Research philosophy Research approach Research strategy Analytical progression Exhibit 2. to describe the application of the research strategy in how we will go about answering our initially stated research questions. to reflect on the different philosophical stances and to demonstrate the nexus between the philosophical approach chosen and the research process. RESEARCH METHODOLOGY This chapter describes the research process in a coherent narrative demonstrating how the research proceeds from the initial research purpose to the final stages of conclusions to answer the research’s question and objectives.

• Last. The revelation of initial thoughts clarifies the initial stance of the researcher towards the research process and manifests how these initial thoughts lead to the formulation of the dissertation objectives. knows which bins are likely to be in play in study and what is likely to be in them”. By doing so the dissertation attempts to separate the wheat from the chaff. 2. Therefore an elementary conceptual framework is formed and displayed graphically to show how the initial thoughts about the research and interrelations about the concepts were developed (see exhibit 2.. reflecting on the methodology in the acknowledgement of its limitations. The investment concept of portable alpha is vetted for its theoretical contributions for pension funds in general and applied to a Dutch setting to obtain the stances of academics and practitioners. Sustainable alpha remains questionable Scepticism towards investment industry claims Allegations investment industry about the relevance of portable alpha Initial stance author Scarce academic literature on portable alpha predominant explanatory focus Portable alpha in contrast to conventional approach liberates the quest for alpha Portable alpha and beta suitable for matching and incremental return purposes Theoretical difficulties inherent to portable alpha were well known The usage of derivatives The management and monitoring of constantly changing factors in portable alpha Exhibit 2.1. The Initial Conceptual Framework In the view of Huberman and Miles (1994): “Any researcher. resulting in an assessment of the limitations inherent to the concept and the (prospective) contributions to Dutch pension funds. Research Purpose The purpose of the dissertation is to identify the relevance of portable alpha in a Dutch pension fund setting. no matter how inductive in approach.2. 2.e.2 – Initial conceptual Framework Tom Oor © 2007 (author) 9 .2). i.

the dissertation inclines strongly to a subjective stance to gain insights through words and meanings retained in a holistic view rather than figures to discover the relevance inherent to a positivistic approach.3. Therefore the most abstracted idea about research originates in the human mind and is determined by its philosophy towards the development of knowledge through research (Remenyi 2002).2. A positivistic approach is characterized by Easterby-Smith et al (1997) as the idea of a social world existing externally. Research Philosophy As Butterfield (1957) remarks: “Knowledge is not handed down to us by some super-human source but is developed by the application of the human intellect”. Saunders (2003) remarks that practical reality. Both ontological stances are widely debated for their perceptions of the nature of the world and the applicability of the methodologies derived from these stances. especially in business research. This philosophical stance clarifies the researchers perception of the world’s being and existence and defines how the study of knowledge should proceed to capture the perception of truth. Nevertheless. Given the exploratory nature of the dissertation illustrated in the initial conceptual framework and the derived objectives. to quote George Homans (1949): 10 Tom Oor © 2007 . In addition. The preferred philosophical stance for the dissertation is realism as it agrees that these research philosophies’ are not mutual exclusive and a hybrid of both stances could enrich and strengthen the results of the dissertation. Research philosophies are often represented by a polemic of two extremes: positivism and interpretivism. Although as Saunders (2003) properly remarks that the strength in acknowledging these philosophical stances lays not within claiming superiority for one of these approaches but the fact that these philosophical stances are more appropriate for different objectives and research questions. is often a mixture of both. objective and its properties should be measured through objective methods inferred subjectively. Interpretivism holds that only phenomena exist and therefore scientist should only study phenomena and the related human experience to understand and explain why people have different experiences and meanings.

This unstructured approach is more likely to yield a holistic view on all factors adding or detracting from the relevance of portable alpha and thus is likely to capture the entire scope of relevance of portable alpha. 2. although not entirely as such an approach lacks initial direction in which everything looks relevant at the start of the research.5. Consequently. Such a research purposes may lead to a protracted process of data emerging beyond the time scope of the dissertation and bears the risk to be unable to arrive at conclusions.4.“People who write about methodology often forget that it is a matter of strategy. 11 Tom Oor © 2007 . 2. The dissertation inclines strongly to an unstructured approach. theory development can be contrasted by either the approach of having a structured process with a pre-existent framework proceeding in a linear mode versus a more unstructured approach based upon rudimentary ideas about the research which are refined during the research process. Research Approach This chapter reflects the process of developing theory throughout the dissertation. Here again Saunders (2003) notes that these approaches are not mutual exclusive. Research Strategy The research strategy is the turning point where the philosophical stance and theory development stance is translated in a hands-on approach of how you will go about answering your research question and objectives and eventually inducing to conclusions. The dissertation inclines strongly to the unstructured approach. In the strictest sense. this lack of rigour and objectivity at the outset lead to a less structured approach to shed light on the relevance as one advances doing research. based upon the following idea of reasoning: The literature review on portable alpha revealed that the concept had not been properly vetted by academics and was lacking a solid framework depriving the research approach from grounding the notion theoretically with a high degree of reliability and thus hampering to impose a definitive framework to derive hypotheses. not of morals”. To prevent this initial structure is provided by the literature review parts of grand financial economic theories and the domain of alpha investing.

To re-emphasize the aim of the dissertation is exploratory seeking to find out new insights on portable alpha and hence the following exploratory research strategy is formulated to answer these set objectives: 2. Literature Review The literature review forms the foundation for setting the thesis for the research which will serve as the initial input for the empirical research. This assures to put portable alpha in a holistic finance and investment perspective and at arrival at the literature review of portable alpha.1.6.The research strategy is not expressed in terms of a generic research strategy but according the purpose of the research and as Robson (2002) endorses this is even considered advantageous as these generic research strategies are not mutual exclusive. According Saunders (2003) such an approach provides the ability to reveal perceptions and underlying meanings of experiences from influential and well-informed individuals in an organization based on their expertise (Marshall and Rossman 1995). This foundation is performed in descending order of abstraction commencing with the deeper underlying economic theories of finance and investments and eventually arriving at the scarce literature on portable alpha. 12 Tom Oor © 2007 . Such a strategy is preferred as these elite individuals are most probable persons to have an insight in the relevance of portable alpha maximising theoretical depth for the given time constraints of the dissertation.7.7. The interview consists of a mixture of fiduciary managers. It adopts a qualitative approach by means of elite in-depth interviews. the primary research focuses on the collection of empirical evidence to gain an understanding of the relevance of portable alpha. 2. these sources lacking peer review can be contrasted to the preceding literature reviews and thus increases reliability. 2. Elite Interviews These elite interviews are conducted with the most influential persons in the Dutch pension fund industry who are most likely to raise understanding in the complex processes of portable alpha. Primary Research Following the secondary research.

In addition. although to get access to these persons is a daunting task. Analytical progression After having conducted the interview. 2.8. Interview Structure The exploratory nature of the research favours an unstructured approach preventing to impose one’s own preconceptions upon the interviewees and let the issues emerge from the interviews (Maylor and Blackmon 2005). This implies that the sample is not taken to be reflective for the pension fund industry but that depth is preferred over width. The ideas obtained in the literature review form the foundation for in-depth interview and functions as a basic guide line throughout the interview. one can not study intensively and in depth all large pension funds and thus the interviews are restricted to a particular population. the ladder of analytical abstraction from Carney (1990) is utilized and adjusted to the approach at hand: 13 Tom Oor © 2007 . less willing to participate in a dissertation and thus making it challenging to get these individuals to consent for cooperation. theoretical saturation should be achieved at 6 in-depth interviews. the interview data follows a process to be transformed in final conclusions by a logic sequence of analytical progression. The Achilles' heel of qualitative research. although a larger sample would be preferable. the aim here is to provide transparency by demonstrating the process of raw data transformation into conclusions and recommendations. Nevertheless. is minimized by triangulating perspectives from a variety of different sources. ambiguous and time consuming process weaving back and fourth between data collection and analysis to ground theory. For this process.2. This does not imply that the interview is an unorganized and non-directive approach but rather that space for anticipation and flexibility is retained to obtain full depth. subjective bias.7. external investment consultants and academics (see appendix 2). Marshall and Rossman (1995) endorse this difficulty and allege that these elite interviewees are busy individuals.Chief Investment Officers (CIO) of pension funds. Data analysis in a qualitative approach does not proceed in a linear fashion and it is messy. 2. Research questions derived from unreliable literature sources are likely to enforce a biased reflection of portable alpha on the interviews. In our case.

Thirdly.(1) Transforming interview tapes into written form (2) Transforming the written raw data into pure raw data by excluding irrelevant information (3) Identifying themes and patterns in the interviews (4) Cross checking tentative findings (5) Synthesis: integrating the thesis and antithesis into an explanatory framework 2. Furthermore reliability is strengthened by preventing the occurrence of biases. As reliability in the meaning of statistical generalization is not a mean by itself for qualitative research. the in-depth interview will be recorded by a memo recorder in consent with the interviewee to retain the richness of the information provided. These criteria are adjusted for their relevance in the chosen research strategy. The interviewer appears properly dressed to convey a serious impression which is likely to yield serious responses. Secondly.1. Reliability is fostered through the usage of principally academic journals serving as input for the interviewees who are all practitioners or academics with a strong track record.9. 14 Tom Oor © 2007 . 2. fostering reliability has only been allowed in case of not “undermining” the qualitative approach. information about the research and purpose are sent a few days prior to the interviews allowing for preparation for the interview. The Soundness of the Research As Lincoln and Guba (1985) notes: “All research must respond to canons that stand as criteria against which the trustworthiness of the project can be evaluated” To judge the quality of the research strategy Yin’s (2003) criteria are applied to the methodology.9. Reliability The strength inherent to qualitative research is to reflect contemporary reality of a concept in its situational context by adopting a flexible approach to fully gain a holistic insight of the concept.

Lastly. the dissertation has focused on strengthening reliability by providing transparency in the form of openly displaying the research process commencing with the initial conceptual framework advancing through the ladder of abstraction into conclusions about the research.9. respondents have been informed about the purpose and contents of the research prior to conducting the interviews. in combination with a literature review grounded in a deeper context beyond our specific context and the usage of reliable objective interviewees enhances the ability to generalise.2.1. 15 Tom Oor © 2007 . a subjective method is used to gain an insight in the relevance of portable alpha being in sync with the aim. External Validity As aforesaid. Although as Yin (2003:37) argues the attempt of the research of a qualitative nature is not so much on statistical generalization but more on analytical generalization and thus providing insights. Based upon the literature review.9. 2. 2. Construct Validity The methodology ascertained that the purpose of the research is properly translated from the general into a specific method covering the aim of the research. Accuracy is improved by setting up a strong academic framework excluding sources with high media content. However the triangulation of interviewee sources. Furthermore. generalization in the form of replicating research findings to larger sample and universes remains daunting for the research.

16 Tom Oor © 2007 .Part II Literature review Part II encompasses the literature review which is formed as a narrative in descending order of abstraction. chapter 3 clarifies the cornerstones of modern finance and investment. Subsequently. Chapter 4 analyzes the domain of alpha investing. Lastly. chapter 5 elaborates on portable alpha. Firstly.

This body of scholarly research on finance and investments is of extraordinarily importance as it infuses all financial theory. alpha itself. In such a world. such as portable alpha (Bernstein 2005). he demonstrated that return is inextricably linked to the risk one is willing to bear and that the rational investor will not disregard risk when seeking return. These abstracted concepts are developed upon the trade-off between abstractionism and realism. analysis and lays the foundation for how participants in the world of finance and investments act and think. Markowitz demonstrated with his Modern Portfolio Theory (MPT) that individual security risk can be diversifiable by holding a portfolio of securities implying that one only has to bear the risk to which the entire 17 Tom Oor © 2007 . Markowitz One of the first great intellects that changed the school of thought on finance was Markowitz (1952) with his remarkable oeuvre. investors maximize their expected utility by balancing return in regard to their risk tolerance. His work has primarily two focal points which were novelties at that time and now dominate the finance and investment universe. especially in the case of Sharpe’s (1964) Capital Asset Pricing Model (CAPM). First. The analytical framework commences with analyzing finance in the most abstracted sense and by advancing the relationship between these theories and the applied concept becomes more apparent. Sharpe (1964) and Fama (1970) and linking these theories to the key concept of portable alpha. THE UNDERLYING CREED The literature review commences with a minor digression on the academic school of thought on finance and investments. The aim of this chapter is to provide an analytical framework based upon the grand theories of Markowitz (1952). 3. exhibiting the notion that investors will avoid taking risk for which they are not compensated. The invaluable grand theories are thus of paramount importance for the proliferation of new concepts in the world of finance and investments. Secondly.1. For the purpose of analysis assumptions have to be made which are not likely to hold.3. these theories and their linkage provide an illustrative aim and tend not to emphasis on the inherent limitations of the models. Hence.

portfolio is subjected. According the CAPM the function of expected return on a financial security depends wholly on a financial assets relation to systematic risk (β) as unsystematic risk is diversifiable. Therefore. Sharpe (1964) demonstrates that through diversification a portion of the risk inherent to a financial asset can be avoided and therefore the price of a financial asset is unlikely to be rewarded for avoidable risk. Consequently in the CAPM an efficient portfolio of assets will have a linear relationship between expected return and portfolio risk implying that an efficient portfolio with a higher beta (β) should shift to the right and cause a concomitant shift in expected return on the other axis(see exhibit 3.2 – The Capital Asset Pricing Model (Sharpe 1964) 18 Tom Oor © 2007 . 3. investors participating in the capital markets expect according Markowitz principles that their (relevant) risk that they are taking will be rewarded with the concomitant return. The Capital Asset Pricing Model Sharpe (1964) made Markowitz proposal more tenable with the development of the Capital Asset Pricing Model (CAPM). Total risk is subdivided into the variability of a financial asset due to the stock market as a whole (“systematic risk”) and the irrelevant residual risk due to company specific factors (“unsystematic risk”). Expected Return R2 R1 Rf β β1 Portfolio Risk (β) β2 Exhibit 3. The model elaborates on the risk/return notion defined by Markowitz.2.2).

necessary for the development of the CAPM. However.2) the expected return of an efficient portfolio equals he risk-free rate plus a risk premium given by the systematic risk of the financial asset and the risk premium of the market (Jensen 1968).Rf] (3. seems implausible in practical reality. supply and demand of financial securities settles at equilibrium point were systematic risk is concomitant with its risk premium.Rf] E(r)β2= rf + β2 [E(r)m . Sharpe (1964) notes: “The proper test of a theory is not in the realism of assumptions but the acceptability of its implications”. E(r) β1 = rf + β1 [E(r)m . In an idealistic financial world.2) E(r) β1 = Expected return portfolio Rf = the one-period risk free rate E(r)m = Expected market return β1 /β2 = Exposure to beta risk The CAPM is essentially underpinned by the economic principles of equilibrium: a state of the world where supply equals demand. Sharpe (1964. As Bernstein clarifies (1999) “Equilibrium is a state of nature that can only exist in the absence of uncertainty. assumptions had to be invoked: (1) all investors can lend and borrow on equal terms and (2) the assumption of homogeneity of investors expectations which are unrealistic assumptions. This rather idealistic perspective on equilibrium is improbable to hold at all times in the financial markets. 19 Tom Oor © 2007 . In equation (3. p433) already manifested that to derive at equilibrium. This equation implies that the expected return is totally dependent on the level of systematic risk and thus a higher beta value results in a higher expected return. only when agents make decisions on the basis of perfect foresight”.In a formula the linear relationship between expected return and market risk becomes more apparent. If systematic risk (β) is the only relevant risk this implies that market forces will push financial assets in quantum leaps to be in sync with their risk reward trade-off and investor returns should equalize to the relevant risk and risk premium. only in a static rather than a dynamic environment. These conditions required for financial markets to be in perpetual state of correct equilibrium.

1) alpha is the risk-adjusted performance of a portfolio in respect to CAPM.. financial assets or financial markets may lend themselves for situations in which the risk premium is not in correspondence with their systematic risk profile (β) resulting in returns that exceed the normal risk premium.2. Jensen (1968) demonstrates that the direction of the alpha can be either. An investor with superb forecasting skills might end up at generating above average returns. A neutral alpha result is one of the possibilities this occurs when the random selection effects in the portfolio nullify each other. this is the so called alpha (α). A negative alpha occurs when the costs to forecast superior returns are higher than the factual returns resulting in a negative alpha (α2) (see exhibit 3.e. positive.2. αp = rp – [rf –βp (rm .rf )] (3.1) Utilizing Jensen’s equation alpha results may be positive.2). i. negative or neutral. R1 Expected Return α1 β Rf R2 α2 β1 Β2 Exhibit 3.2. neutral or negative but also alpha can be generated either by (Warwick 2000): 20 Tom Oor © 2007 . In such a case.1 –Graphically display of alpha performance (author) Jensen (1969) developed a performance metric to measure the alpha component in a portfolio. positive alpha (α1). In this equation (3.In practical reality it is reasonable to assume that this artificial concept of equilibrium does not hold and that the price of financial assets will not entirely be a function of market risk and its concomitant systematic risk premium.

the small cap effect leads. i. abnormal profits. Mandelbrot and Hudson 21 Tom Oor © 2007 . markets were inefficient in properly setting financial asset prices. irrational behaviour is likely to persist being endorsed by a large body of academic evidence (Shiller 2000. 3. With the advent of the EMH the state of market efficiency was challenged and alleged that markets were efficient until such an extent that all publicly available information was fully incorporated in the security price (Ambachtsheer 1994)..e.. In other words. although this could also be a higher risk premium for illiquidity reasons (Fama and French 1992).3. although there is still a huge body of academic evidence on efficiency or near efficiency.(1) Investments returns that yield higher returns than their benchmarks for similar risk (2) Investments with a similar risk profile yielding excess returns To quote Bernstein (2005) “the CAPM is a theoretical triumph and an empirical disaster insinuating that the assumptions required to abstract the model and arrive at equilibrium are far from realistic. In practical reality financial markets deviate from the correct equilibrium for financial asset prices providing leeway for alpha. Then again the proliferation of academic evidence in the last 20 years refutes this stance and financial markets appear to be less efficient than presumed (Malkiel 2003). arguing that as long as stock market participants remain human beings. i. The consensus about the efficiency of the market appears to be divided. In this context the argument of Bernstein (2005) seems plausible. asset prices do not coincide along the CAPM line but settle in equilibrium at a different level allowing for bearing higher risk.e. For instance. The State of Market Efficiency Prior to the arrival of Fama’s (1970) Efficient Market Hypothesis (EMH) the world view dominated that diligent research was rewarded with higher returns. although until which extent holds this deviation from efficient financial markets? The answer to this question is more likely to be a transitory truth than a universal truth. in comparison to large caps to higher profits. An additional perspective is to argue that markets are efficient and that these markets adjust themselves to incorporate additional risk factors.

Fama (1970) analyzed the state of efficiency of the financial markets and thus the scope for alpha investing. Without their respective theories measuring and identifying alpha would be difficult if not impossible. In such a world. these abnormal profits or statuses of disequilibrium can’t be perpetual and as Miller (2000: p.2004 and Tversky and Kahneman 1974. given that the financial market is in perfect equilibrium. 3. pricing irregularities and predictable patterns in the stock markets can appear over time and even persist for shorter periods of time. 22 Tom Oor © 2007 . 1979) Consequently.1) says: “Abnormal profits wherever they are found inevitably carry with them seeds of their own decay”. it is probable that alpha will continue to emerge and submerge in different occasions and financial markets. the notion of market efficiency is more a transitory truth than a universal one. The important point is that prior to the theories of Markowitz and Sharpe analyzing investment performance would not have been possible. Furthermore. Nevertheless. meaning that markets are in eternal state of convergence and divergence towards perfect equilibrium.4. The CAPM makes these propositions more tangible and demonstrated that one is only rewarded for market risk and thus financial asset prices are a function of systematic risk in respect to their financial market. the CAPM has many assumptions to make the model work and arrive at equilibrium. Although. in cases where this does not apply might demonstrate where alpha can be generated. Conclusion As has been manifested these grand theories caused an extraordinary leap in human thinking in the area of finance and investments providing the nexus between the underlying theories and the conceptualization of alpha. Markowitz (1952) exhibited that risk and reward are inextricably linked and that not all risk is relevant and therefore not rewarded.

Alpha management strategies are based on applying information to achieve 23 Tom Oor © 2007 . hence the term “active management” (Sharpe 1991). Investors holding a belief that a particular market is not highly efficient and thus providing leeway for alpha. The aim is to elucidate the characteristics of alpha investing and its context in portfolio investment. The name of passive investing might lead to the assumption that passive investing is total passive. ACTIVE MANAGEMENT: THE QUEST FOR ALPHA The former literature review on the underlying grand theories demonstrated that these invoked the conceptualization of alpha. The key issue in building alpha portfolios is the usage and application information analysis. The active manager refuses to accept average returns and tries to beat his asset or style benchmark. Investors believing in a strong form of market efficiency. asset class or style benchmark as calibration point and tracks the selected benchmark in the preferred level..1. The Domain of Active Management To what extent one beliefs in market efficiency and thus the settlement of financial assets at the correct equilibrium price influences one’s stance and approach to investment. investors compose a portfolio that will yield above average returns. i. This chapter performs a literature review on the particularities of alpha investing which are central for the understanding of portable alpha. in respect to the chosen benchmark. 4. This passive approach takes a financial market. These managers usually trade on perceptions of mis pricings which tend to change relative frequently and thus require active trading to exploit these pricing misperceptions. alpha. however even in a passive modus trading takes place to rebalance the portfolio as it deviates from the selected benchmark. are inclined to agree with market average returns (“equilibrium returns”) as in such markets outperformance is a daunting quest. in which obtaining abnormal profits is only for the rare few. In the endeavour to pursue alpha. employ passive portfolio management. Investors convinced that markets approach high levels of efficiency.4.e. will attempt to have above average market returns.

However by composing alpha portfolios no manager has enough skill to yield alpha without undertaking additional risk. Thus. In this beta universe. investors attempt to capitalize on market inefficiencies and deviate from a market risk diversified portfolio exposing them to idiosyncratic risk. According Sharpe’s (1964) principles financial markets function in such a way that investors are solely rewarded for relevant risk. To illustrate this. active risk (Waring and Siegel 2003). which is irrelevant risk and thus not rewarded. Additionally. Therefore this risk is conditionally rewarded and contingent upon the probability of the alpha manager to yield alpha in the financial markets. could there be noted that the principles of arbitrage are likely to force beta risk and return within their premium profiles.. Information is therefore crucial for predicting alpha and the transformation of these alpha forecasts in portfolios (Grinold and Kahn 1992). Market Risk and Active Risk: Unconditional and Conditional Rewards In the search for alpha. i. Therefore riskier financial markets provide a higher risk premium than financial markets subject to less market risk.e.e.superior returns by forecasting alpha returns that are not yet impounded in the price and translate these forecasts in alpha portfolios. total risk is subdivided according Sharpe (1964) into (1) market risk and (2) active risk with their distinct implications for investments. This distinction between market and active risk lies at the heart of alpha investing. managers deviate from market risk and expose themselves to active risk. In an alpha universe. The probability of generating alpha is a so called zero-game because obtaining alpha goes at the expensive of other market participants (Waring and Siegel 2003).2. 4. to buy financial assets at an incorrect equilibrium price. an investor holding a diversified market portfolio is expected to be rewarded with a risk premium according to the market’s risk. 24 Tom Oor © 2007 . In such a case. i. market participants are betting against each other. At aggregate level market returns are shared by all market participants and in the quest for alpha. managers with superior forecasting skills are likely to build alpha portfolios. consciously or unconsciously. market risk and the return premium are inextricable linked and thus market risk is unconditionally rewarded.. Investments in alpha or beta universe are subject to different risk principles. market risk.

total risk is Pythagorean (see exhibit 4. Total Risk (Active risk + policy risk) Active Risk Risk of the Policy Benchmark Exhibit 4.The conclusion here to be drawn is that investing in alpha and beta universes are conditionally and unconditionally rewarded.1).2. Investors deal differently with these two types of risk and have different risk aversions for market and active risk (Grinold and Kahn 2000)..e.2 – Alpha and beta risk aggregation (Waring et al 2003) Although Waring et al (2000) demonstrate that this is improbable to apply in portfolio context as investors apply different risk aversion to market and active risk. i. 25 Tom Oor © 2007 . This different risk aversion stance seems logic as investing in the market is unconditionally rewarded by the market average return whilst taking active risk does not per se materialize in generating the foreseen alpha. Therefore the actual “felt” impact of active risk on the portfolio is significant larger on total portfolio risk (see exhibit 4. The distinction of market and active risk in portfolio context is well explained by Waring et al (2000) demonstrating that due to these different risk aversions the real impact of active risk is much higher than one would assume. These authors manifest that aggregating active risk and market risk under similar risk aversions would result in portfolio risk that is not much lager than beta risk in isolation.2). This discloses the “real” impact of active risk on total portfolio risk and explains the prudence of investors in engaging in alpha investing.

as Waring and Siegel (2003) say as long financial market participants’ difference in intelligence and skill level persist. Numerous academics have challenged Fama’s (1970) EMH that markets are improbable to attain semi-strong levels of efficiency and that public information occasionally might lead to alpha. In addition. it is likely to assume that financial markets lend themselves for alpha. 26 Tom Oor © 2007 .2. This chapter analyses the scope for generating alpha and the likelihood of active risk being rewarded. The foremost factor to be present is an inefficient market to provide leeway for alpha returns. there has been manifested the difference in policy risk and active risk with their different implications for investment portfolios.3. Although academics do not seem to have consent on the state of market efficiency. The conclusion was drawn that investors have a different risk aversion towards active risk and therefore will be more cautious in taking active risk to exploit alpha.“Felt” Total risk Active Risk Risk of the Policy Benchmark Exhibit 4.1 – The real impact of aggregating alpha and beta risk (Waring et al 2003) 4. although it seems plausible to assume that as long as financial markets are not completely efficient there is leeway for alpha returns. Alpha Returns: the Alpha Universe In the previous chapter.

(Leibowitz 2005). 4. Hence. market inefficiencies might exist this does not make them immediately suitable for alpha extraction. As aforesaid.Not all financial markets are comparable in their state of efficiency or inefficiency. it is reasonable to assume that not all 27 Tom Oor © 2007 . exploitation may be impeded by counter forces or technical restrictions or they may resolve quickly. they are not all equitable to serve the purpose of alpha investing. it is the human intellect applied to information analysis and transformation of such an analysis in a portfolio that determines the ultimate success of alpha. Thus. The Human (skill) Factor Given that market inefficiencies exist. These market inefficiencies can’t be perpetual otherwise active risk would be unconditionally rewarded and this would of course be the holy grale. In aggregate all these market participants in the market will earn the return on the market. The argument is made that market inefficiencies may be unstable and unpredictably have under and overshoots. In such a context. therefore positive alpha by investors needs to be balanced by negative alpha by others. Some markets might attain levels of almost perfect efficiency in such a market the scope for alpha investing becomes very challenging. Other financial markets might attain lower levels of efficiency providing other possibilities for generating alpha. As Leibowitz (2005) emphasizes. market inefficiencies should be lengthy and sufficiently stable for the alpha strategy to be worthwhile. even tough market inefficiencies exist. it seems sensible to undertake active risk for the pursuit of alpha. These patterns of inefficiency change as financial markets transform and shift one from state of equilibrium to another. Nevertheless market imperfections with a degree of sustainability are not sufficient. in certain instances have a degree of sustainability and are likely to persist.4. This dynamic feature reduces the propensity for alpha engines to be consistent and thus worthwhile to exploit. alpha investing is a zero-sum game in which market participants bet against each other. This multitude of financial markets provides an entire scale of alpha extraction possibilities. In case of imperfectly efficient markets. such an equilibrium transits from one state of inefficiency to another state of inefficiency.

Consequently. it is skill that might lead to persistent alpha performance. it is of paramount importance to separate the wheat from the chaff: distinguish between managers’ capabilities to yield alpha and through mere luck. although the existence of superior active managers is endorsed by the academic literature Brown and Goetzmann (1995) confirm that as well superior and inferior fund performance is inclined to persist over consecutive years. Managers demonstrating consistent above average performance are not numerous. For investors including active managers in their portfolio. Harlow and Brown (2004) argue that investors can improve their probability of choosing suitable active managers by recognizing that past performance is more likely than not to repeat. although it is likely to assume that the level of heterogeneity in market participants’ intelligence. These investors are seeking for managers that could lead to consistent alpha performance. differences in information and skill level is likely to persist and add up to alpha returns (Waring and Siegel 2003). it is unlikely to assume that skill will lead to perpetual alpha as market inefficiencies change over time. In the short run managers could generate alpha through skill or simply a degree of luck. Litterman (2003) argues that the proliferation of mutual funds in the last decade serves as an additional testimony to the ability of human skills to exploit alpha. Chen et al (2000) and Baker et al (2005) demonstrate that stock picking skills by individual managers exists and translates into higher performance. 28 Tom Oor © 2007 . However.investors will beat the market returns or create positive alpha. Investors are looking for alpha managers with skill which serves as an indicator for sustainable performance. For those lacking the skills the probability that active risk will be rewarded with alpha returns decreases as potential alpha performance can’t be predicted with a degree of certainty. Perhaps for investors lacking the skill of recognizing superior managers it would wise perhaps to not engage in active investing. Moreover. the task for an investor wanting to utilize alpha managers is to identify these superior managers capable of generating alpha. In equilibrium this zerosum game would not be possible. Since luck is not under the control of the investor and might evaporate.

After having determined the customized benchmark. managers’ performance is contrasted to a benchmark or a well diversified portfolio. In the quest for generating alpha. i. as Arnott and Bernstein (1990) remark: “risk is such a many headed monster that selecting the right head to focus on can be a major challenge. In a multi-factor approach. Therefore a multi-factor model such as the arbitrage pricing model propounded by Ross (1976) is suggested to be more purposeful in explaining market risk and thus used for developing an adequate benchmark. the CAPM model was used to decompose risk in a market and active risk component to distinguish between market returns and alpha returns. The designation of a benchmark to an alpha manager will severely impact the alpha performance. managers have a benchmark target and a tolerance set for deviation of this benchmark. 29 Tom Oor © 2007 . By beating the benchmark his total performance consists of a part exposure against his benchmarks and generated alpha.4. resulting in the so called pure alpha. Without having benchmarks it would be impossible to quantify alpha performance as there is no calibration point for comparing the risk and return of the active manager. The Benchmark In the quest to yield alpha. In a real world context. In active management. This deviation from the benchmark is the so called tracking error defined by Tobin (1999) as the percentage difference in total return and index fund and the benchmark index the fund was designed to replicate. the tracking error represents the proportion of active risk undertaken relative to the benchmark. it is unlikely that a single beta-factor model is complete in explaining market risk and alpha returns might have a different exposure to market risk than desired. how many active risk may the manager undertake.. For simplicity reasons. managers’ returns are explained in terms of beta exposure to these different factors. the managers’ task is to beat his assigned benchmark in the quest for alpha. therefore their definitions of relevant risk might differ and set different benchmarks. The valuable contribution of the manager is not his total return but solely the portion of the return over the benchmark. However. Pension funds are improbable to all be subject to exact similar risk factors.5.e.

Measuring Investment Performance: The Information Ratio The information ratio (henceforth IR) relates all the aspects of alpha investing discussed so far. how much alpha is generated in respect to deviation from a given benchmark (see equation 1). .75 is very good and 1. Hence. the IR is dependent upon alpha and the active risk undertaken represented by the tracking error. as long as the active returns causes a proportionate change in active risk the value addition of the investment strategy remains constant and hence employing a more offensive strategy which is met with a proportionate shift in alpha does not translates in a more valuable active investing strategy (Waring and Siegel 2003).6.4.6) α = Pure active return σ = Pure active risk [Tracking Error] In the equation. This has two important implications: (1) All investors investing according mean-variance objectives will prefer the highest possible IR (2) Investors with high risk aversion will be less aggressive in exploiting the information and will thus have lower value added strategies Although what is considered an appropriate relation between active risk and alpha? Grinold and Kahn (2000) alleged that an IR of . In other words. The IR represents the amount of alpha per unit of active risk undertaken to achieve this outperformance. It is the ratio utilized to determine the value addition of an alpha manager and according Grinold (1989) perhaps the single most important metric for this purpose.0 is 30 Tom Oor © 2007 .5 is good. Information Ratio = α /σ (4. The IR makes it possible to compare the added value of investment managers with a very different risk/return trade-off A very offensive alpha strategy taking a lot of incremental risk which yields a concomitant alpha has the same added value as a defensive alpha strategy with less incremental risk rewarded with concomitant alpha. relative measured to a benchmark. to arrive at the value addition of an investment strategy.

Some of these constraints are imposed by governments. Investment is confronted with several forms of constraints impeding alpha performance. Levy and Jacobs (1996) argued for similar figures and quantified that a good manager might have a . in the real world investors often face restrictions that hamper their ability to maximize alpha and thus the materialization of the forecasted IR. fiduciaries impose constraints on their investment managers by narrowing the investors’ freedom to act and thus limiting the full scope of available opportunities to generate alpha. Grinold (1989) emphasis this point and asserts that the IR ratio should be considered as an upper boundary for analyzing the value addition of an investment strategy. regulators. although it is very illogic to employ an alpha manager with a certain style that is impeded by these fund constraints and thus unable to deliver the expected alpha even staying with the defined risk budget and boundaries.5 and an exceptional manager attains 1. A constraint with a very severe impact according Litterman (2005) on an investment mandate is the restriction to take place in short-selling resulting in holding a long-only portfolio. The exclusion of short-selling limits the scope of activity and thus engagements of alpha strategies that require short-selling.exceptional. the suggestion goes that pension fund trusts should weigh if their set investment constraints are in sync with manager’s skill. although others are self-defeating.0 level. as issues hampering alpha performance and costs for generating alpha have not been subtracted. Also Jacobs et al (1999. Therefore. Litterman (2005) demonstrates how certain constraints set by pension fund trustees interfere with an investment manager’s alpha strategy whilst remaining within the set risk limits resulting in a lower IR. Some of these constraints are totally logic to control excessive risk.7. of course until the extent that he’s able to deliver the IR identified by the pension fund. Alpha Performance Constraints The information Ratio is based upon the assumption that the pursuit of alpha can be done without any restrictions. It appears logical to curb investment managers’ ability to act by rules set at the fund level. Nevertheless. Within these frameworks. the financial markets and apply to the collective of investors. 31 Tom Oor © 2007 . 4.

This restriction in portfolio context leads to suboptimal usage of alpha performance. not all alpha investing strategies are based on high-turnover and pension funds in the Netherlands are exempted from paying taxes. Especially. 32 Tom Oor © 2007 . These costs for an alpha strategy can be broadly defined in two cost posts: (1) costs of generating the information and (2) costs associated with the investment strategy. Investors are considered with total wealth creation net of all costs and alpha strategies are quite cost intensive in comparison to passive strategies. Additionally.1997) demonstrate the positive effects of abolishing long-only portfolios. i.8.. the emphasis has been on alpha on paper.9. the scope of alpha investing for individual portfolios has been discussed. Arnott and Jeffrey (1993) demonstrated in their empirical evidence the impact of turn-over generated taxes on alpha investing and concluded that most manager’s alpha are thus not large enough to cover taxes. Waring et al 2000). alpha strategies encompassing a high turnover strategy subject to capital gains tax (CGT). However. alpha prior to all expenses. The Costs of the Quest for Alpha Thus far. For large institutional investors alpha decisions are taken at aggregate and are a matter of constructing a portfolio of active managers. 4. they argued that overlay strategies might counter the tax effect for high-turn over alpha strategies and this is exactly what a portable alpha strategy is.e. active investors are liable to tax obligations increasing the barrier for alpha investments to be profitable or worthwhile. In addition. 4. Building Active portfolios: Maximizing Alpha Returns In the latter chapters. As Grinold (1989) mentions that strategies with a high turnover are more probable to have a larger proportion of costs since such a strategy requires high transaction costs and more active trading. In a portfolio context the aim is about optimizing total active return against total active risk whilst dealing with misfit risk between individual managers to maximize expected return for a given level of risk across all active managers (Waring and Siegel 2003.

the expected usefulness of the alpha portfolio equals expected alpha of the alpha managers combined minus the combined active risk.Efficient Frontier of Alpha Managers (Waring et al 2003) 33 Tom Oor © 2007 .9).9). λα 2 = the degree of risk aversion.9 .At aggregate level the active portfolio has the following expected utility (see equation 4. Simply stated. E(αp) = expected alpha on the portfolio. E(σ2A) (4. E(Uα) = E(αp) . Furthermore expected correlation between managers’ alpha’s are required and of course their exposure to the market factor that describes the normal portfolio.9) E(Uα) = the expected utility of the active management component in the portfolio. This active risk in portfolio context includes active risk of the individual and the misfit risk across the portfolio.λα . Moderate Risk Expected alpha [ E(α)] Higher Risk No Risk Active risk (σ) Exhibit 4. In balancing active risk and return across the portfolio. E(σ A) = the active risk of the portfolio aggregating individual manager risk and net misfit risk across the portfolio This equation can be used to draw an efficient frontier for the investors desired level of risk aversion for active risk (see exhibit 4. expected alpha performs a key function in portfolio optimization as active risk is optimized against expected alphas.

although the results of alpha might justify the effort. Theoretically speaking. The value Addition of Alpha Alpha investing is a difficult process and conditionally rewarded. Although. It appears to be logic for alpha investing to be uncorrelated with beta sources as alpha investing is dependent upon market inefficiencies and human skill to extract these. alpha might provide incremental returns. The other benign factor is obviously alpha returns itself.4.10. practical reality has proven that these alpha strategies do display some form of correlation (Kung and Pohlman 2004). 34 Tom Oor © 2007 . Which investor is not seeking for above average market returns? Especially at times of relative low returns on the capital markets. pure alpha returns are uncorrelated with beta returns and thus risk reduction (mean-variance) can be achieved to reduce overall portfolio volatility.

the limitations and difficulties inherent to the approach are discussed. Portable alpha is contrasted against the conventional investment approach to make the benefits apparent. The Concept In the essence. 5. These derivatives are used as a synthetic overlay on the portfolio neutralizing the beta and resulting in residual alpha of the manager.1. Therefore in a portable alpha universe. The literature review clarifies the functioning and the aim of the concept. the concept of portable alpha according the definition of Coates and Baumgartner (2006): “A financial engineering methodology that seeks to add low correlation sources of return (alpha) to a portfolio while maintaining the total portfolio’s desired systematic (beta) exposures” The core of portable alpha is based on the notion that the quest for alpha is separable from the portfolio’s desired beta exposures. Furthermore. which can be entirely or partially unwanted for the portfolio. PORTABLE ALPHA This last part of the literature review arrives at the concept portable alpha. i.5. its asset allocation policy.e. These alpha returns are thus separated from their beta source and are ported back to the portfolio of investments without having to change the underlying asset allocation of the portfolio resulting in a portfolio optimized for the desired alpha and beta exposures (See exhibit 5. financial derivatives are employed to liberate alpha from their underlying asset classes.1).. In this concept the entire alpha universe can be used for finding appropriate alpha sources to be included to the portfolio’s beta investments. Conventionally speaking the quest for alpha sources results in ending up in beta exposure. 35 Tom Oor © 2007 . investors having located an interesting market for alpha extraction have to invest in the market to extract alpha and normally would have to expose themselves to markets which are out of sync with their asset allocation policy. In other words.

the stance on deviation from the asset allocation is set. Therefore both approaches are contrasted to demonstrate the effects of portable alpha in a pension fund investment context. The Portable Alpha Approach versus the Traditional Approach The benefits of a portable alpha approach in isolation are perhaps not that evident. Hereby the asset allocation decision is inextricably allied to investment decisions further down the line and the quest for alpha has to be pursued within the asset classes and their proportions. In the simplified exhibit 36 Tom Oor © 2007 . i.Alpha source Neutralizing the undesired β by means of derivatives Portable alpha Portable beta Total portfolio α Undesired market exposure α α β β β Exhibit 5.1. Does the fund allow for strategic deviations from the intended policy or is the portfolio allowed to drift with the whims of the financial markets? Ultimately.e. Consequently. The traditional investment approach follows a top-down investment structure.The portable alpha concept (Gerritsen 2006) 5. the strategic asset allocation dictates the investment process. These might become more apparent by comparing the traditional investment approach and the portable alpha approach. the decision is made whether to employ alpha or beta management of a portfolio. the first decision is the asset allocation decision determining how the total investment portfolio shall be subdivided in asset categories and weightings. To put this decision fist appears logic as Brinson et al (1986. active versus passive management. thus starting at macro-level narrowing down the scope. Arnott (2002) remarks that thus in such a traditional approach. In exhibit 5.. In this approach.2.2 the process of a conventional portfolio is explained and illustrated with fictive numbers. 1991) demonstrated that the choice of asset classes and weightings of these asset classes have the largest impact upon investment performance.

2 – Conventional portfolio approach (Author) First. risk budgets are set in accordance with the proportions the asset have and induce a concomitant alpha.Equity = αint.Equity Alpha risk reduction effect Suboptimal correlation (ρ) Exhibit 5. therefore selecting managers that have non-correlated alpha styles is limited. Hence.2) E(rα) = Expected Return on the Alpha portfolio W IR = Weighting of the asset class = Information Ratio Secondly. the result of alpha performance is the weighted average of the asset classes multiplied by the suboptimal IR (see equation 5. Therefore. Then again alpha strategies have to take place within the asset allocation mix.Equity) (5.5. this automatically excludes managers with IR that do not fit within the asset allocation decision. E(rα) = (WBonds IRBonds ) + (WEquity IREquity ) + (WInt.2 the quest for alpha is limited by the three asset classes (bonds. the 37 Tom Oor © 2007 . equity (. Furthermore. Thirdly is the inability for reducing total alpha risk in the portfolio.Equity /σInt.Equity IRInt. alpha has to be generated within the asset classes and these proportions.2).4) IREquity= αequity / σEquity Int.5) IRBonds= αbonds / σBonds Equity (. the information ratio can’t be optimized because alpha within these market are given and increasing the risk budget does not trigger a disproportionate alpha resulting in a higher IR.1) IRInt. equity and international equity) and their respective weightings. To put the asset allocation decision first and abiding by it in the strictest sense has the following implications for alpha in portfolio context: Investment portfolio Asset Allocation decision (β) The scope for alpha Bonds (. Hence.

the portable alpha approach frees the investment policy from the Janus faced nature.2.1). this effect becomes apparent in equation (5.possibility for optimizing an alpha portfolio is limited because IR returns and the risk reduction effect are determined by the asset allocation mix.2. The alpha portfolio is given a risk budget and the entire continuum of alpha sources can be used to compose an optimized portfolio.2.2/.2. Hereby. the investment portfolio ends up with alpha and beta decisions which can be optimized in isolation (exhibit 5.1.1).1) Investment portfolio α portfolio IRoptimized= αhighest prospect / σrisk IRoptimized= αhighest prospect / σrisk IRoptimized= αhighest prospect / σrisk Theoretical optimized correlation (-1ρ) Practical reality (-. σα= (WBonds IRBonds) + (WEquity IREquity) + (WInt. At aggregate level the investments are subdivided in a beta and alpha portfolio (see exhibit 5. The application of an overlay.Equity IRInt. using derivatives neutralizes the undesired beta and arrives at the desired total asset allocation.2. expressed in terms of volatility ρsuboptimal = Suboptimal correlation In contrast to the conventional approach.1) σα = alpha portfolio risk.Equity) + ρsuboptimal (5. The selection of alpha sources outside of the asset allocation mix might conduct the fund to unwanted beta exposure inherent to these alpha sources (Arnott 2002).1 – portable alpha approach (author) 38 Tom Oor © 2007 .2 ρ) β portfolio Exhibit 5. this has been demonstrated in exhibit 5.

The beta portfolio encompasses the “passive activities which are constructed to match the cash in and outflows. 39 Tom Oor © 2007 . portfolio effect calculation will show that with higher expected returns of a wider alpha universe and a lower correlation or even negative correlation. However.In a portable alpha portfolio.. and thus a valuable contribution. The strength of portable alpha can be summarized by permitting a suboptimal portfolio assuming two roles inefficiently to be divided into two efficient portfolios resulting in an optimal joint portfolio. a simple. In such a case. Alpha managers can be selected for high IR and also for strategies with the lowest correlation possible reducing overall alpha portfolio risk. In retrospect to equation (5. alpha managers can be selected for a higher information ratio (IR) adjusted to the risk aversion of the pension fund are probable to translate in higher expected returns. the risks mount slower than the alphas.2. although as Arnott (2002) demonstrates that the assumed uncorrelated strategies turn out to have low correlation and thus effects might be less promising than in theory. the assets and liabilities. In the portable alpha approach. expected returns can be optimized by filling in the alpha risk budget with the highest prospective alphas in the right proportions resulting in the highest expected return on the alpha portfolio.e. widening the scope seems plausible.1) it becomes evident that there is “total freedom” in maximizing expected returns. The joint portfolio is characterized by which the sum of the two parts has a lower active risk versus the liability than in the conventional approach (Kneafsy 2003). each portfolio component fulfils a distinct function which was united in the traditional approach. The second issue is allowing for optimizing the risk reduction effect. i. The alpha portfolio is assembled irrespectively from the beta portfolio and as Waring et al (2000) argues in the context of alpha investing: “Whenever there is a trade-off between expected return and risk an opportunity for optimization exists “. Obviously in such a wider alpha universe.

1 – The Alpha Continuum (Coates and Baumgartner 2006) The continuum of alpha investing strategies displays that there is an optimal zone of alpha strategies. An Optimal Alpha Source The first objective of investors employing a portable alpha strategy and also the most crucial objective is to find a consistent. The literature review of active investing (chapter 4) manifested that alpha strategies are conditionally rewarded and that these factual risk aversions are much higher.3.1. The chapter reveals the limitations and the inherent difficulties of porting alpha back to a portfolio.1. sustainable and significant source of alpha (Coates and Baumgartner 2006) that also matches the active risk profile of the investor. 5. The Conceptualization in Depth This chapter focuses in depth on demonstrating the process of portable alpha as demonstrated in exhibit 5.3.3. the alpha universe can also be displayed according a risk/return continuum of expected alphas and the risk factors attached (see exhibit 5.1) Aggresive active ´Optimal´ portable alpha zone Alpha potential (E (r)) Optimal active Too much risk Too little return Enhanced Indexing Pure Indexing Tracking error (σ) Exhibit 5. hence investors are likely to be more prudent in selecting alpha sources. This zone of optimality is characterized by the notion that investors should undertake a considerate portion of active risk to yield alpha that has an impact on 40 Tom Oor © 2007 .3.5. Even though the alpha risk/return trade-off is no guarantee.

Another limitation to the portable alpha approach is that not all alpha sources are covered by financial derivatives. Excluding the ability to short-sell causes a declining information ratio. the scope for alpha investing tends to be restricted by the fiduciaries of a pension fund imposing restrictions on the fund and its alpha managers to act in total discretion. Asset classes in which there are no appropriate derivatives.2. The usage of derivatives to obtain beta exposure. As demonstrated before an alpha investment strategy yielding an information ratio . 5. alpha and beta can’t be detached from each other implying that the investor has to invest also in the beta source to obtain alpha shifting the asset allocation mix.5 is good and 1 pertains to exceptional performance and is unsustainable in the long-run. Some of the relative new asset categories such as private equity. These aspects raise the bar for alpha investing to be profitable and require reflection before selecting an alpha source. real estate and forestry 41 Tom Oor © 2007 . Although. Restriction to Alpha Sources Fortunately or unfortunately. although it matters much more if the alpha does not materialize. an alpha source must outweigh the cost of transporting alpha. An additional issue is that in portable alpha. given that the level of skill of the active manager remains constant (Waring and Siegel 2003).3.the portfolio. This is simply a graphical explanation of optimal alpha investing strategies according Grinold’s (1989) information ratio. In such a context the selection for appropriate managers becomes even more important. cash management for required derivative liquidity and alpha management fees to align performance and to be rewarded for performance bear costs. this depends on the ability of the fund and its fund mandates to short-sell financial assets witch is often prohibited limiting the scope for alpha diversification.and over performing financial assets. Kahn (2000) demonstrates that enhanced index funds and market-neutral long-short funds to have approximately a double expected information ratio than long only funds. The focus of alpha investing tends to be preliminary on financial assets providing superior performance in respect to their benchmark whilst Jacobs and Levy (1999) demonstrate that alpha can be generated from either under. As Arnott (2002) comments these portable alpha structures might not be that onerous against a high forecasted alpha.

3. This involves the process of subtracting market exposure (β) from the outperformance resulting in the residual of pure alpha (α). although these markets by themselves might not be very effective for alpha extraction (Kung and Pohlman 2004). implying that outperformance displays no correlation with the underlying markets. This wide array of financial derivatives has a distinct trade-off profile for using as neutralizer in a portable alpha strategy.3. An investor pursuing alpha opportunities on a small cap index (Russell 2000 small-cap index) short sells futures contracts in the amount equally to the portfolio’s value. Neutralizing encompasses the process of obtaining beta exposure by means of derivatives resulting in the desired residual alpha. This process of neutralizing the underlying asset class can be done by short-selling or long-selling and thus and obtaining alpha trough outperformance as well as underperforming asset classes. For illustrative purposes and example from Jacobs and Levy (1999) is provided to clarify the process of neutralizing a beta source. The residual of pure alpha is considered as the Holy Grail in portable alpha. 42 Tom Oor © 2007 . expanding the scope for portable alpha strategies. The advent of derivative markets and the abundant proliferation of financial derivatives in the last decades have rendered the market less dear and cover a greater extent of underlying financial assets. Derivative Overlay: Alpha Decomposition After having selected an appropriate alpha strategy. The remnant between the portfolio’s return and the small cap-universe return is considered pure alpha and reflect the manager’s ability for outperformance. financial derivatives are used as contra weights to neutralize the alpha component from the priory estimated beta component. 5. the separation of alpha and beta follows. By investing in the index whilst at the same time short selling an equal amount of the portfolio’s will nullify changes in the value of the portfolio and makes the portfolio beta neutral to the small cap universe.which have no financial derivatives as contra weights. For these separation purposes.

Jacobs and Levy (1999) argue: that even in spite of these costs the potential benefits of portable alpha are substantial. in a swap contract there is also left room for a changing spread which is probable to be dependent upon the ease for hedging the contract. In addition. although how plausible is it that large banks facilitating these products will not settle their contracts? Jacobs and Levy (1999) demonstrate that also the swap is subject to similar conditions as futures. an illiquid future market increases the cost by having a higher bid and asks spread. not all asset classes and benchmarks are represented on the futures market and even when they are present they might not be liquid enough to support the institutional size. Thus markets which are easier to hedge should have lower hedging costs and have lower swap costs. Also. increases the tracking error from the policy benchmark and short term mispricing could occur in the future market resulting in short-term tracking error. increase rollover risk due to the fewer market participants. The drawback of futures are that they are market-to-market daily and thus require some of the risk budget to be committed to cash management of the initial margins and the respective changes of the value of the futures. Futures facilitate investors with liquid tools to obtain easy and inexpensively market exposure to an underlying financial asset which are marked-to-market daily. Swaps are over the counter (OTC) arranged contracts. Therefore. Perhaps one should remember that a liquid market is more likely to be covered by futures although liquid markets also increase market efficiency and thus decline the scope for alpha investing. Furthermore. futures are arranged on a futures exchanges minimizing counter party risk. Swaps are another financial derivatives found suitable to utilize for portable alpha. the terms in the swap can be stated to perfectly match the policy benchmark taking away the mismatch between the swap and the benchmark. Often the argument is made that these OTC products are subject to counterparty risk. 43 Tom Oor © 2007 . (Hull 2000).The preferred method for obtaining beta exposure is future contracts (“futures”) due to their favourable characteristics.

although this complicates the process.4) with major indices. correlations might converge/diverge over time resulting in a deviation from the desired exposure (Coates and Baumgartner 2006).3. Investors tend to prefer alpha sources with the lowest correlation possible to the underlying source clarifying that these alpha returns are pure alpha An inextricable beta proportion does not make an alpha source obsolete to use in a portable alpha strategy. Kung and Pohlman (2004) illustrate the low correlation questionability by examining beta neutral hedge funds employing long short strategies displaying positive correlation (. The inseparable beta portion that adheres to the alpha source is difficult to gauge with precision. the result of pure alpha is unattainable and beta remains embedded in the residual alpha.5. Even if alpha and Beta separation might result in a pure alpha strategy. Implementing an overlay strategy based on improper measurements of the embedded beta results in under or over exposure and results in unwanted risk (Coates and Baumgartner 2006). implicit beta might be present. An alpha source with implicit beta is not totally uncorrelated with the underlying source and is subject to market risk exposure. Jensen (2003) remarks due to the opaque nature of external alpha generating resources such as hedge funds. deviance from the alleged alpha strategy has also a different impact than expected on the portfolio. Derivative Overlay: The Inherent Difficulties Nonetheless disaggregating outperformance in an alpha and beta component is on paper seemingly straightforward but in practices this process is surrounded with sheer complexity. Brittain et al (2005) endorse the hidden beta exposure of hedge funds to an even larger extent of hedge fund strategies. In most sources.4. In case of generating alpha by an internal manager employing a particular agreed alpha strategy. 44 Tom Oor © 2007 . the beta source might be instable and requires constant adjustment to rebalance risk and unwanted beta exposure.

5. The capability of pension funds to be able to support a portable alpha strategy is improbable to apply for all pension funds. The support of such a structure can heavily draw upon organizational resources. Such an investment structure should be able to deal with the complexities inherent to a portable alpha structure (Coates and Baumgartner 2006) In a portable alpha structure. although it requires a radical change in portfolio management to cope with the increased complexity.5. Therefore.4. The portable alpha approach can be implemented to varied extents within a portfolio ranging from using the process in a portion of a single asset class until the full extent as has been demonstrated. This draws upon organizational resources to monitor and manage this rebalancing process. there are components constantly moving and often simultaneously. The Portable Alpha Extent For simplicity reasons and the explanatory purpose. Another issue is the management of derivatives with their basis and cash settlements. Therefore as Coates and Baumgartner (2006) argue applying the process partially onto the conventional structure might be an idea to probe the waters for pension fund fiduciaries. depending upon the extent to which to implement portable alpha. often a change in infrastructure is required to support and monitor effectively the portable alpha process. Without proper management the portfolio is likely to drift from the desired goals. the portion of embedded beta and the derivative overlay. although implementing the portable alpha approach entirely is likely to impact the portfolio in the full extent. the idea was aroused that either one had to choose between either portable alpha or the classical approach. Pension funds should have the capabilities to provide organizational resources for portable alpha. portable alpha might seem fairly clear-cut. This is not necessarily the case. An option might be outsourcing investment 45 Tom Oor © 2007 . The shift from the conventional approach to a portable alpha approach is a radical change in the mindset of pension fund trustees. 5. Portable Alpha Management: The Operational Procedures At the surface. This concerns changes in the alpha strategy itself.

6. (3) Therefore the portfolio is separated in a beta portfolio matching assets and liabilities and a return portfolio. i.e. Framing this in the academic body of knowledge vets the notion portable alpha although does not provide us with actual information about the stance of practitioners and academics about the concept. The actual interest for the concept is that with relative low returns on the capital markets investors in combination with the Dutch Financial Assessment Framework (FTK) imposed by the Dutch Central Bank (DNB) pension funds are looking to redeploy their investment policies. how well do assets match liabilities? At times of relative low returns it becomes therefore difficult to match future assets and liabilities.management increasing the costs and this should be weighed against the additional benefits 5. the focus remained on framing portable alpha in a solid and reliable academic framework. Portable Alpha in a Contemporary Context Thus far. 46 Tom Oor © 2007 . (2) Nevertheless higher returns do per se mean an enhanced match of assets and liabilities. According Garrido (2006) portable alpha strategies are not new and have been around for more than two decades. The FTK assesses pension funds on their ability to meet their future liabilities. Therefore according Gerritsen (2006) a portable alpha structure in contrast to the conventional approach sustains pension funds in meeting or outperforming liabilities based on the following line of reasoning: (1) The separation of alpha and beta due to the portable alpha construct results in a better balance between market risk and active risk and thus increases the expected portfolio return on the pension fund.. This scarcity of academic research on the relevance of portable alpha seems logical knowing that the conceptualization is mainly driven by the investment industry and it’s difficult to speak of interplay between practitioners and academics.

2006. This seems sensible knowing that relative low returns of beta risks have a concomitant return and alpha risk is not guaranteed. The nucleus of current interest for portable alpha can be summarized by the quote of Calio (2005): “The long horizon risk of a pension plan is that it will not have enough assets to defease liabilities. in times of relative low returns on the capital markets pension funds modify their risk budgets from the asset allocation segment of their portfolio to alpha sources (Garrido 2006). a total portfolio separation has occurred with Dutch pension giant PGGM. Instead of only partially implementing a portable alpha strategies and thus porting one source of alpha to a fixed asset class. Payne 2006) for a variety of reasons. these arguments are subjective opinions of industry experts: (1) A take off is not occurring due to questioning whether investors can produce alpha consistently (2) Furthermore pension funds are prudent in exploiting such an approach which is insufficiently examined. 47 Tom Oor © 2007 . although caveat lector. although exploiting market inefficiencies are independent from beta returns and therefore become relative more valuable to undertake in times of low returns on capital markets. With the pursuit of these portable alpha strategies in earnest. it is difficult to speak of consensus about the relevance of portable alpha for the pension fund industry.Kennedy (2006) similarly contends that the incubation of portable alpha strategies as liability-driven investment tool is taking place. and so makes porting of alpha the most important part of the structure` To complement. On the other hand claims have been made that pension funds are hesitant to act upon portable alpha strategies and are in the wait and see modus (Calio 2005. Whereas others such as the Dutch pension fund Bedrijfstakpensioenfonds Metalelektro (PME) has applied the concept partially and increases its risk budget dedicated to portable strategies. portable alpha strategies have become more complex. Seemingly.

This should not immediately discard the statements made and thus the relevance of portable alpha. bear in mind that these sources discussing portable alpha are not subject to peer review and usually involves parties with a conflict of interest. although this should be considered.One should. however. 48 Tom Oor © 2007 . These arguments made by investment managers are undermined by objectivity knowing that the probability is present that their economic interests of sales to institutional investors is intertwined with their arguments.

Lastly.Part IIIResearch Analysis Part III commences by displaying and commenting on the results obtained from the elite in-depth interviews analysis in chapter 6. Hereupon. 49 Tom Oor © 2007 . chapter 7 will discuss the implications for the relevance of portable alpha based upon the literature review and the elite in-depth interviews. chapter 8 will synthesize the findings of the report into answering the dissertation’s main question and key objectives.

Hence. 6. The reason for adopting a portable alpha approach differed and insights provided were not straightforward. PGGM has applied the portable alpha concept to the full extent and the portfolio is separated into alpha and beta components in which alpha can be ported from “any” suitable alpha source. although taking into consideration the probabilities and risks of underfunding. Key findings are displayed and lastly transformed into a conceptual framework to result in a holistic perspective. the largest pension funds under management Openbaar Vervoer (OV) and Spoorwegen Pensioenfonds (SPF) both have an actual funding ratio of respectively 140% and 180%. ANALYSIS OF THE IN-DEPTH INTERVIEWS This chapter analyses the findings obtained from conducting the empirical research. The raw data collected in the interviews is yet abstracted from the lengthy interviews and coded into key findings of relevance (appendix III).6. PME uses portable alpha mandates in its portfolio. The decision to optimize the active risk budget was taken in the context of having the ability to do so. also the extent to which portable alpha has been applied to the portfolio differed. The intention was to optimize active risk by including portable alpha managers with large tracking errors to the existing portfolio whilst maintaining absolutely low correlation amongst these alpha managers. Additionally.1. Portable Alpha at Dutch Pension Funds The empirical research demonstrated that portable alpha is used amongst the pension funds and under the management of the interviewees. pension fund trustees have decided to have a larger opportunity portfolio. In addition. The IBM pension fund was found in a state of changing investment policies and is currently contemplating change in its investment policies such as an alternative 50 Tom Oor © 2007 . According Van Iersel (2007) the fund was seeking to optimize its active risk budget by adding portable alpha mandates to its investment portfolio. although Van den Brink (2007) emphasizes that these mandates are not held for the structure but for the alpha skill of the manager that otherwise would be unattainable. the profiles of the interviewees have been included (appendices II).

concern the largest pension funds in the Netherlands and Van Aalst (2007) emphasizes that at the entire industry the concept of portable alpha is not a widely debated topic and the discussion remains predominantly at the top tier Dutch pension funds concerning the 20 to 30 largest. Therefore. might lead to a protracted process: (1) Scepticism towards new investment products and strategies (2) Requires a radical change in mindset of the pension fund trustees (3) The inability to monitor the desired (B) exposures (4) The sustainability of alpha remains questionable 51 Tom Oor © 2007 .investment portfolio. Even in the latter portable alpha is more talked about than implemented. however. The interviewees included in the sample. Although to discuss the relevance of portable alpha was not yet possible as internal knowledge about the concept was not available. Van Aalst (2007) explains that this gap between concept and application of the concept is not per se a reason to discharge the relevance of the concept. also endorsed by Van den Brink (2007). the application of portable alpha and the future developments of the concept are depending upon the following factors. and scepticism towards the investment industry. Such an incubation period between the conceptualization of portable alpha and implementation is often a long and justified process to vet the concept and discover the difficulties and inherent drawbacks.

the investment industry has been quite successful in selling old wine in new bottles. Griffioen (2007) also demonstrated that the pension fund just commenced looking for more advanced investment strategies such as alternative investment portfolio but actually the pension fund trustees were not able to judge about the relevance of a portable alpha strategy.6. In this context. especially in contrast to the conventional investment approach. Allegedly. Pension fund trustees bear the ultimate responsibility for their respective pension fund.e. Scepticism towards “New” Investment Products and Strategies Pension funds are quite sceptic towards the emission of investment products or strategies on the market by investment firms.. Therefore these trustees should fully understand all the implications of a portable alpha structure which is in some instances not the case.2. In addition. Van Iersel (2007) explained that the pension fund trustees were not yet ready to embrace the concept. Van Aalst (2007) remarks: “the enterprises supplying portable alpha promote this concept in such a manner pretending much more under the pretext of portable alpha than would be reasonable to assume”.1.1. it becomes difficult for pension funds to separate the wheat from the chaff. which concepts are really relevant for pension funds.1. The interviewee Van Aalst (2007) perceives this sceptic stance of the pension funds towards the introduction of new investment products and strategies as a barrier to acceptance and implementation. Van den Brink (2007) endorses this scepticism by the investment industry’s attempts to anew develop investment products which utility have not much changed only the repackaging of the concept. i. Griffioen (2007) explained that portable alpha as investment strategy requires a lot of knowledge about the concept which is currently not 52 Tom Oor © 2007 . Investment firms providing solutions for pension funds have done this in such a way that these pension funds have become quite sceptic towards “new” investment products and strategies. An implementation of a portable alpha strategy requires a radical shift in thinking about the proceedings of an investment policy. although a total portable alpha approach might be anticipated in 3 to 5 years. 6. A Radical Change in Mindset The concept of portable alpha is quite difficult to grasp.

6. Although for the additional approximation of 690 Dutch pension funds would the implementation of monitoring a portable alpha concept remains difficult.3.4. Van Aalst (2007) clarified that smaller pension funds make use of custodians to monitor asset managers and the behaviour within these asset mandates. 6. although the constant monitoring of beta exposure and alpha manager correlations is excluded from the scope of possibilities. A high IR could occur a few years successively although will eventually have to return to more sustainable levels if the market does not become efficient and according Van Iersel (2007) this does not happen over night. He argues that a critical examination of alphas demonstrate that these are far from sustainable and thus in case of portable alpha there remains no alpha to be ported back to the portfolio. In 53 Tom Oor © 2007 . An implementation of portable alpha process for these smaller pension funds puts the responsibility and ability of such a process at the custodian. The Sustainability of Alpha However. In case of a portable alpha approach. Difficult to Manage Portable Alpha Pension funds differ in the size of assets under management. the eternal discussion remains sustainable alpha. The larger pension funds in the Netherlands.1. The majority of these custodians in the Netherlands and the states are able to monitor the behaviour of an asset manager and the usage of derivatives.1. Van Iersel (2007) complements this view by demonstrating that alpha strategies with higher information ratios (IR) a higher degree of disappointment can be expected since these high IR are unlikely to be sustainable. in particularly ABP and also PGGM with large internal organizations supporting the investment process have few difficulties to implement an advanced investment process such as portable alpha but these two pension giants are not very representative for the entire industry (see appendix 4). this requires monitoring beta exposure and hedging away beta exposure.available internally and therefore the pension fund has been more restricted to conventional asset classes and a more simplistic investment approach. abide by different investment policies and organizational structures to support these policies. According Van Aalst (2007) sustainable alpha leads in many cases to disappointing returns.

Alpha Investing at Dutch Pension Funds Empirical evidence demonstrated that the pension funds included in the sample make use of alpha investing in their investment portfolios. 6. thinking in alpha and beta terms poses another challenge: the requirement of a benchmark to measure performance. In spite of his (sceptic) stance towards alpha investing the pension funds under management by Mr. 54 Tom Oor © 2007 . Van Aalst (2007) is sceptic about the value addition of alpha investing in the equity markets but he had the belief that bond markets lend themselves for alpha generation because interest rates can be predicted in the medium-run. Beta investments can be obtained and managed quite inexpensively therefore the industry had to find other ways. The smaller Dutch pension funds tend not to participate in alpha investing.1. Van den Brink (2007) is sceptic about the notion alpha itself and argues that the term largely serves the investment industry for profit making reasons. such as alpha investing to increase profits. Although. The issue where pension funds think to obtain these alphas is disputable. Van den Brink does participate in alpha investing.2. The Relevance of Alpha: The Situational Context of Portable Alpha 6. Van den Brink (2007) clarified that there is a subdivision in pension fund size and their engagement in alpha investing. Consequently.such a case. timing is of the essence for determining when a very high IR will revert to more sustainable performance and thus reducing the exposure to the strategy. Whereas the mediumsize and the larger pension funds do participate in alpha investing.2. thinking in terms of a benchmark and investing according a benchmark impacts performance by thinking that the benchmark is without risk. although the majority believes that larger tracking errors are allowed for emerging markets in the hope these translate into considerable alphas. However. especially in equity does contribute to higher returns. In which the former is more restricted by the conventional approach in selecting alpha sources than the latter. Van Aalst (2007) endorsed that the belief held at Dutch pension funds is that alpha investing.

The Alpha Contribution to Portfolio Returns The entire sample of interviewees demonstrated that the relevance of alpha investing has to be put in a proper context. In defining portfolio returns for a pension fund alpha contributions are often a minor factor in impacting portfolio returns. Hence. In such a case. Beenen (2007) illustrates the potential impact of these small relative contributions of alpha 55 Tom Oor © 2007 . The argument of such performance is based on figures from the database of Keith Ambachtsheer statistically displaying that pension funds that are prudent in exploiting active risk and remain an approximate balance of 80/20 have a better performance than pension funds taking more active risk. Van den Brink (2007) remarks that pension funds that are prudent in exploiting alpha investing have on average better investment returns than pension funds that supersede such a balance between active and passive management. the subdivision of these asset categories into countries and markets has the second largest impact in explaining portfolio returns. Subsequently.2. Therefore portable alpha strategies predominantly based on freeing the selection of alpha to include a wider array of alpha sources is unlikely to have more relevance than the total impact of alpha performance on portfolio returns. the so called asset allocation decision.2. the decision of alpha investing is one of the last decisions to take and attributes relative little to the overall portfolio returns. Essentially the lion’s share of the portfolio returns are determined by beta exposure. The last decision with the least impact of these decisions is whether to passively or actively invest in the financial markets of choice. Within these confines of alpha contribution to the portfolio the relevance of portable alpha has to be sought. The configuration of these beta risks has the largest share in explaining portfolio returns. Nevertheless.Lastly. 6. as Van Aalst (2007) demonstrates even within a pension fund context these relative small contributions of alpha investing may translate into billions of incremental portfolio returns. the foremost decision explaining portfolio returns is the division of the portfolio in assets with different beta risk/return trade-offs. Therefore it is unlikely that portable alpha will be decisive for whether a pension fund will be poor or rich in term of financial assets.

As Beenen (2007) mentioned the higher the return aim of the portfolio the more difficult it becomes to achieve these levels and alpha investing is daunting but may be very rewarding.investing in the long haul results in the case of PGGM could approximately result in a 25% reduction of payments for pension fund contributors. although it has the probability to add abnormal yield and thus to increase the total return on the portfolio. However.2) Balanced alpha proportion translates on average in higher portfolio returns Small impact on total portfolio returns The contribution of alpha investing in portfolio context The boundaries of relevance for Portable alpha Important contribution: the ability to add outperformance Exhibit 6. The subdivision of the portfolio in asset classes is likely to result in portfolio returns according the risk and correlation profiles of these markets. the impact of alpha investing on the portfolio as a whole might be little. Controversially. it does have the ability to higher the returns on the portfolio. Pension funds employing a proper balance between beta and alpha risk have on average superior portfolio performance than pension funds superseding the appropriate balance (See exhibit 6. the impact of alpha might be relative small. Pension funds returns are primarily determined by the configuration of beta exposures and alpha returns have a relative small impact on the portfolio. Ultimately.2 The Contribution of Alpha to portfolio investment (author) 56 Tom Oor © 2007 .2.2. These interviewees pointed out that the relevance of alpha and the derived applied concept of portable alpha has to be found in the contribution to pension fund portfolio returns.

6. 57 Tom Oor © 2007 . one needs more or less 6 months to be able to evaluate performance. Concluding these daunting aspects inherent to alpha investing persist when employing a portable alpha mandate or applying a portable alpha structure to the entire portfolio. one should question the substitutability of an alpha manager. There are no guarantees that the alpha manager will perform the forecasted performance and track records and a degree of “gut feeling” about the investment strategy could increase probability but still does not assure success that the anticipated alpha strategy will materialize. This lies however more complicated for internal managers who can’t be fired so easily.3. These human elements attached to alpha investing increase complexity.3. Additionally. Hence. the idiosyncratic factors of portable alpha are displayed and analyzed. portable alpha remains subject also subject to these traditional alpha investing difficulties. After the selection of a manager. Conceptual Findings Hitherto. Monitoring is to ascertain that alpha managers maintain within their investment styles and tracking errors. the discussion concerned general issues about alpha investing that emerged during the interviews. In this chapter. Selecting alpha managers for the management of alpha mandates is a cumbersome process. If an alpha manager deviates from his style is it a temporary aberration or perhaps the end of a profitable alpha strategy? The ability of good timing is therefore also essential and complex. the discussion shifts from the general domain of alpha investing to portable alpha. In the beginning of a new manager. Officially the legal documents (“the legals”) provide the ability to suspend a manager quite easily and within a short time notice. Portable Alpha Remains Subject to Classic Alpha Investing Difficulties Although conceptually more complex than conventional alpha investing. the monitoring of performance phase commences.6.2.

In these newer financial markets under development it becomes more difficult to speak in alpha and beta terms because. Investing in the FX markets is based on speculating to know it better than the median of market participants. an alpha manager’s mandate has two utility functions: (1) the manager manages the assets under management and (2) attempts to generate alpha.2. These asset classes identified mainly concern infrastructure.6. the conventional approach is not per se restraining the alpha selection process and Van Aalst (2007) argues that even in the conventional approach one could select 58 Tom Oor © 2007 . there is no benchmark to contrast returns and difficult to identify alpha and port this “alpha”. in some cases.3. Non-Conventional Asset Categories Pension funds are contemplating and. the manager is solely chosen for his generation of alpha. have expanded their investment portfolio to non-conventional asset classes.3. As Van den Brink (2007) notes: “someone investing from the beginning with skill in such new opportunities should this be considered alpha?” The line between alpha and beta returns is blurred in these markets and how should one separate those returns and port them back to the portfolio? A similar issue occurs in the Foreign Exchange (FX) market. he does not add any value. In the FX market one can’t speak from beta returns as it is a market for exchanging currencies and not for exchanging capital with its concomitant risk/reward premiums. The Portable Alpha Manager In the conventional approach. Therefore.1. However. If such a manager does not succeed to generate alpha. allegedly there is no beta. Portable Alpha: A Portfolio Division in Alpha and Beta Portfolios The conventional approach is often accused to be a limiting factor for choosing alpha sources and this has been one of the alleged strengths of a portable alpha approach. industrial timberland (CMA). life settlements and CAT bonds. 6. In these markets it becomes thus cumbersome to distinguish between alpha and beta returns. In a portable alpha concept. In the conventional approach this would be less of a concern as the manager still added value through managing the mandate. 6.4.

and alpha source and hedge away the beta risk of the selected source. This totally depends upon the organization of the pension fund.

Van den Brink (2007) clarifies why the conventional process does not have to be a limiting factor for alpha investment, particularly not for large and medium-size pension funds. The argument stated is that these medium sized pension funds have less knowledge of investment in general and are less likely to operate at the frontiers of knowledge leading to a more restricted policy defined by the asset allocation decision. An additional statement demonstrates that the smallest category of pension funds the asset allocation decision is not applicable because they do not enter the field of active investing.

The larger pension funds (PME) are not hampered by the asset allocation decision and can seek the alpha where found suitable. The usage of derivatives has been allowed since the beginning and can be used for investment purposes. However, Van Iersel (2007) demonstrates that in the assets under management derivatives can only be used for long strategies resulting in suboptimal active portfolios.

The interview Van den Brink (2007) makes a distinction between the process of portable alpha and an external portable alpha mandate. These large pension funds have the flexibility to adopt a portable alpha approach internally because of the ability to use derivatives and the knowledge about investment practices available. Such a large pension fund would “only” use an external portable alpha mandate for obtaining the manager’s alpha skill allied to the mandate which would otherwise not be possible to obtain.

For medium-size investment pension funds the potential use of a portable alpha strategy has to be found in structuring such a mandate and the skill set of the manager directing the mandate. These medium-sized pension funds require portable alpha mandates to be able to source alpha from a wider selection of sources which normally speaking would not be possible by the asset allocation decision and limitation of derivative usage in the portfolio.

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6.5. The Asset Allocation Argument: Decoupling Alpha and Beta The decision to separate a portfolio in an alpha and beta component is contingent upon the funding ratio of the pension fund. Until recently a large portion of pension funds found themselves in situations in which their funding ratio was situated between 100% 105% under such circumstances pension funds have no option than to invest everything in their beta portfolio. Given these conditions pension funds need all or such a significant part of their portfolio for matching purposes, because the value of their investment were just a little bit more than their obligations, and one should question if a subdivision would be sensible for such a small fraction of the portfolio? Therefore, one might conclude that under low funding ratios such a large portion of the total portfolio is required for matching purposes that it would perhaps be insensible to actively manage, with all its efforts and costs, such a small portion of the portfolio. Van Iersel (2007) endorsed that an official separation of such an entire portfolio into an alpha and beta component is probable to happen and anticipated in a 3 and 5 years time span. The aim of such a portfolio would be to use the beta portfolio for matching the assets and liabilities and the alpha component will serve the quest for alpha managers, pairing the two will be done using swaps. Van Iersel (2007) remarks that internally the organization is already managed in an alpha and beta portfolio, although the pension fund trustees are not yet comfortable with an official alpha and beta separation. Beenen (2007) argues that a total portable alpha approach makes it possible to take cross asset bets which would be impossible in the conventional structure

Van Aalst (2007) disputes that the separation of an entire portfolio into two portfolios optimized for their respective purposes seldom results in an efficient portfolio at an aggregate level. An inefficient portfolio at an aggregate level is not per se a grave issue, as there are more occasions in which pension funds operate suboptimal because dealing with an optimized portfolio can be very difficult to manage. Therefore pension funds should be aware of the trade-off between sub-optimized risk/return portfolios versus the facility to manage such a portfolio. Beenen (2007) demonstrates this concept of inefficiency between the alpha and beta portfolio in which the alpha and beta portfolio engage in controversial activities. However the fund has an organizational structure in place which assures coordination between the two portfolios counteracting inefficiency.

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6.6. The Conceptual Framework: Relating the Variables The relevance of the notion portable alpha has to be perceived in a wider context, i.e. what’s the relevance of alpha investing for pension funds? The aim of portable alpha is to decouple alpha and beta sources to provide the ability to select alpha sources with no restraints, insofar that the beta source does not dictate where alpha will be obtained. Hence, the relevance of portable alpha can’t be more relevant than the contribution of alpha investing to the portfolio, as portable alpha aims to add alpha performance (see exhibit 12).

The challenges inherent to alpha investing remain applied to a portable alpha approach. The identification of alpha managers continues to be crucial for successful alpha investing. Hiring alpha managers based on a track-record and a fair portion of gut feeling does not assure the foreseen alpha. Similarly, monitoring alpha performance is essential to prevent managers to deviate from their alpha styles. The issue with monitoring is to determine whether such a deviation is temporary? Timing performance is of the essence to increase/decrease exposure, although remains very difficult to execute with precision. Furthermore, to keep the information ration stable and reducing exposure of an alpha manager requires a perfect substitute which is unlikely to be instantaneously available. Additionally, the restriction of short sales in pension funds results in suboptimal alpha portfolio. Pension funds allowing their mandates to short sell are able to benefit from negative alpha. This restriction on alpha management hampers the potential effect of portable alpha as sources for negative alpha have to be excluded.

The conceptual findings displayed that portable alpha is limited by the nature of the financial market. In newer investment categories such as mainly infrastructure, industrial timberland (CMA), life settlements and CAT bonds the identification of alpha remains complex due what should be considered alpha performance. Furthermore, in these markets the line between alpha and beta returns is blurred and how should one separate those returns and port them back to the portfolio? Therefore, not all financial markets are suitable as an alpha source subject to the portable alpha process

61 Tom Oor © 2007

Another limitation is of course the use of derivatives which are indispensable for portable alpha. Furthermore pension funds of these sizes operate less at the frontiers of knowledge and thus have to adhere more strictly to the conventional approach hampering alpha performance. Theoretically speaking. The larger pension funds tend to operate more at the frontiers of knowledge and have less limitations imposed by the fiduciaries than the medium-sized and small pension funds. portable alpha will not have any relevance for these smaller pension funds. medium-size pension funds and large pension funds with similar organizational capabilities and practices. The additional risk of Over-The-Counter (OTC) derivatives. Hence. Pension funds operating less at the frontiers of knowledge are likely to exclude derivatives from their investment policies but are also less likely to manage a portable alpha structure. If one sees counter party risk as a serious factor whilst dealing with large creditworthy banks as a risk. measuring and monitoring correlation and beta exposure appears very straightforward. Partially implies adding portable alpha mandates to the structure and by doing so optimize the risk budget. Roughly pension funds can be dividend into small pension funds. The majority of these custodians are capable to monitor the usage of derivatives in a mandate although the consistently monitoring of all moving factors in a portable alpha approach such as beta exposure remains outside the capabilities of a custodian. Smaller pension funds tend not to engage in alpha investing. one should not partake in the financial markets (Van Iersel 2007). counterparty risk is not a substantial issue. Medium-size pension funds do actively participate in alpha investing and do so in the form of selecting managers through investment mandates. These pension funds are capable of implementing a portable alpha partially or to the full extent. Fully implies a total separation of the investment 62 Tom Oor © 2007 . The ability to do so is dependent upon the organization of the pension fund. These investment mandates and their respective performance are under supervision by a custodian. The research demonstrated that the conventional approach is not per se a limiting factor for the selection of alpha sources. In practices this is much more challenging and a pension fund is less concerned with small percentile divergences or convergences and more with the change of correlations in large financial market corrections.

in which the interrelations become evident. The decision to separate a portfolio in an alpha and beta component depends upon the funding ratio of the pension fund in question. Therefore a conceptual framework has been developed (see exhibit 6. However. A subdivision in an alpha and beta portfolio results in a suboptimal portfolio at the entire portfolio level. such a process facilitates the management of these individual portfolios and renders it possible to use the entire continuum of alpha sources.7) to show the variables into a holistic portrayal. 63 Tom Oor © 2007 .portfolio in alpha and beta sub portfolios. All these variables in isolation do not properly depict the empirical findings.

The conceptual Framework (author) Difficult to measure correlation of alphas 64 Tom Oor © 2007 . process Alpha performance timing element α Relevance depends on organization al context Medium size Pension fund Empirical findings: interrelating the variables β Inability custodian to monitor a portable alpha process Inclined to abide by the conventional approach.2) Sustainable alpha Remains questionable Alpha manager selection diff. Although are also most likely to abide less strictly by the classical approach Alpha investing In portfolio context (see exhibit 6.Portable alpha remains subject to classic alpha investing factors Balanced alpha proportion translates on Small impact on total portfolio returns Important contribution: the ability to add Total portfolio separation into portable alpha and portable beta Large Pension fund Use portable alpha mandates to optimize active risk Have the organizational capabilities to implement and monitor portable alpha.7 . therefore portable has relevance to optimize alpha Conceptual revelations Do not operate at frontiers of knowledge limited Asset Allocation policy Small size Pension fund Tend not to engage in alpha investing Although. these are also the most incapable to monitor and manage the process Non/conventional asset classes limitations Reduced utility portable alpha manager Portable alpha has no relevance Counterparty risk OTC little relevance Limitations to use derivatives Exhibit 6.2.

Consensus on the relevance of portable alpha remains unattained To arrive at definitive conclusions pinpointing out the relevance of portable alpha remains complex. illustrating the functioning of the concept. although throughout the interviews two central points of 65 Tom Oor © 2007 . In fact. Van Aalst (2007) argues that portable alpha is predominantly driven by a practitioner’s audience and one can barely speak from interaction between practitioners and academics vetting the notion. compare and synthesize the findings from the literature review and the empirical research. Assumedly the allegations made by the investment industry with their intertwined economic interests about the importance of the concept are improbable to apply to all Dutch pension funds. FINDINGS AND DISCUSSIONS This chapter will discuss. Amongst the Dutch pension funds the concept of portable alpha is not widely debated and the discussion remains primarily at the largest pension funds (Van Aalst 2007). The interviewees all pertain to the larger pension funds in the Netherlands and all indicated that portable alpha was employed either by using portable alpha mandates or applying the concept entirely to the investment policy in case of PGGM excepting IBM.1. it seems plausible to assume that portable alpha has been around prior to Levy’s publication date and thus is no novelty (Garrido 2006). This process will result in representing the findings obtained during the dissertation.7. Implicitly the interviewees did not reach consensus about the relevance or irrelevance of the concept. Academic evidence tends to remain in the explanatory phase of the concept. 7. essentially is portable alpha a derivative overlay strategy and these overlay strategies do exist since the advent of the first financial derivative bourses. the findings and results from this synthesis are displayed graphically to make the interrelations between the conclusions more apparent. Although. Lastly. the inherent drawbacks and initial claims on how it might contribute to optimizing the alpha risk budget and thus increase the information ratio. The conceptualization of portable alpha or alpha transport has been around for many years and Levy (1999) was one of the first vetting the notion academically.

Arnott (2002) demonstrated that portable alpha in contrast to the conventional approach allows for optimizing the information ratio (IR) for a given risk budget at portfolio level. indeed. Van Iersel (2007) strengthened the relevance by arguing that such a separation might be anticipated in the medium-term. is used for optimizing the alpha risk budget. However. The implicit argument made by Van Iersel (2007) explains that: “the addition of portable alpha mandates with high tracking errors and absolute low correlation leads to a more optimal alpha risk/return portfolio” This displays that portable alpha. the IR can solely be maximized by finding higher alpha generating strategies. Waring et al (2003) complement this view point by demonstrating that the utility of an active portfolio is to optimize total active risk against total alpha return dealing with misfit risk. This is not particularly a grave concern taking into considerations that there are more situations in which operations occur inefficiently because managing an optimized portfolio can be very complex. 66 Tom Oor © 2007 . This argument is well vetted by Grinold’s (1989) IR metric displaying that in isolation for a given active risk level.relevance emerged coinciding with the line of thoughts of Arnott (2002) and Kneafsy (2003). which have separated the investment portfolio into an alpha and beta component. Van Israel’s (2007) line of reasoning corresponds with the latter argument of Arnott (2002) being well grounded in the alpha investing literature by Grinold (1989) and Waring et al (2003). that suboptimal practices occur due to opposing actions at these different portfolios. conventional alpha investing difficulties remain applicable to the process of optimizing the information ratio. Kneafsy (2003) takes the effects of portable alpha even further and explains that it allows for separating a suboptimal entire portfolio fulfilling two roles (matching liabilities and abnormal profits) into two efficient portfolios which at aggregated level result in an optimal joint portfolio. Van Aalst (2007) refutes this statement and claims the contrary: subdividing a portfolio and optimizing them for two different policies seldom results in an entire efficient portfolio. Beenen (2007) arguing in the context of PGGM.

Additionally. if the status quo on the financial markets directed pension funds to alpha structures allowing for efficient alpha contributions as Gerritsen (2006) argues. Van Aalst (2007) identified that this decision to totally separate a portfolio according alpha and beta to be worthwhile also depends upon the funding ratio of the respective pension fund. if the introduction of the new financial assessment framework (FTK) had an impact on the selection of portable alpha mandates. the interviewees did not clarify whether their interest for portable alpha partially or entirely can be found in contemporary developments such as relative high funding levels of pension funds providing and the possibility to contribute more to active risk budgets and thus portable alpha to become more worthwhile. Hence. the relevance of portable alpha remains difficult to pinpoint exactly. In such a context. 7. Consensus about the optimization effect of the portfolio at aggregate level is not achieved. Neither. but is unlikely to surpass the contribution of alpha to a portfolio as a whole. A pension fund that requires a disproportionately large portion for matching purposes because financial assets exceed obligations by such a small margin that it seems implausible for the management of such a small fraction of financial assets be worthwhile. The contribution of alpha commences by the identification of Sharpe (1964) separating risk in an alpha and beta component. The relevance of portable alpha is found in the contribution of alpha to pension fund portfolio returns The essence of a portable alpha strategy is to allow for constructing an optimal alpha portfolio irrespective of the required long-term beta assets. Unfortunately. Beta is the relevant risk and therefore unconditionally rewarded whilst alpha is conditionally rewarded upon a myriad of factors demonstrated in the literature review and improbable to always results in 67 Tom Oor © 2007 . Hence.2. the relevance of portable alpha is allied to the results of such an alpha portfolio to the portfolio as a whole. definitive conclusions can’t be drawn whether portable alpha allows optimizing two portfolios with different aims to results in an entirely efficient portfolio. as aforesaid. Nor.

. all interviewees view coincided with the notion that alpha is important although beta risks inherent to the asset allocation decision explain the lion’s share of the portfolio returns over time as demonstrated by Brinson et al (1986. This simple implies that one can’t total up these two risk factors with dissimilar portfolio utilities and if done so provides a distorted picture of real total risk. total risk is not much larger than beta risk in isolation. Essentially. Furthermore.e. Van den Brink (2007) put practical flesh on the bones by arguing that pension funds maintaining approximate balance of 80% beta versus 20% alpha risk have on average a better performance than pension funds exceeding this balance and taking more alpha risk. 1991). Therefore investors incline to construct portfolios which relative low levels of alpha risk whilst it appears that alpha risk has barley impacted total portfolio risk. i. Arnott (2002) proves the theoretical optimization of information ratio by a portable alpha approach in portfolio context. 68 Tom Oor © 2007 . Although as Waring et al (2003) demonstrates investors apply a different risk aversion to alpha investing and the amount of felt risk increases substantially reducing the utility of alpha in the portfolio. Rationale pension funds should approximately adhere to the balance between alpha and beta risk identified by Van den Brink (2007) and endorsed by the academic literature Brinson et al (1986. Synthesizing these views on alpha investing sets the proper situational context of portable alpha in portfolio context. although as demonstrated factual total risk has considerately increased. These differences in risk rewards induce investors to deal differently with these risks and apply two different risk aversions to alpha and beta risks. 1991). although pension funds are unlikely to exploit this to full the extent due to the implicit higher alpha risk aversion applied reducing portfolio utility. Under similar risk aversion stances. a portfolio aggregating alpha and beta risk would result in total risk fulfilling a Pythagorean function.positive alpha. Short-term deviations may occur and are dependent upon the funding ratio to employ an alpha portfolio with a potential higher information ratio. this determines that in the long run applying a higher risk budget to alpha investing would negatively impact long-term returns.

Coates and Baumgartner (2006) identified implementation nuances posing management challenges to manage and monitor properly a portable alpha process. Pure alpha remains questionable and often a portion of beta adheres to the individual alpha mandates. Practical limitations to the theoretical concept have been identified Additionally. to the complexities inherent to alpha investing. Pension funds require being conscious of these complexities to judge whether portable alpha will be a valuable solution for them. Consequently. investing in portfolio context is often a dichotomy between apportioning the risk budget to alpha or beta sources. 7. Then again. Such a beta portion inherent to an alpha strategy constantly changes as alpha managers deviate from their strategies. apportioning a more aggressive beta mix does have the ability to increase portfolio return with higher probabilities but does not have the risk reduction effect inherent to alpha investing. portable alpha exposes the pension fund to additional factors. The ever-changing factors in a portable alpha approach make it a difficult process to manage. However. Van Aalst (2007) remarks that the exceptional pension funds could easily facilitate such a process. the pureness of alpha and thus the totally negative correlation between alpha and beta sources is often elusive and alpha does display a degree of correlation with beta sources.3. Furthermore. and custodians are able to monitor these derivatives. when permitted by the respective fund. and monitoring and managing such a process is out of the scope of the greater part of the custodians. The interviewees demonstrated that financial derivatives are used in investment mandates. financial derivatives are used to obtain the required beta exposure. Pension funds contemplate either to increase return by making the trade-off between employing a more aggressive beta mix or dedicate a larger part to alpha investing. although for the pension funds making mainly use of custodians to monitor investment mandates this could be a serious obstacle. 69 Tom Oor © 2007 . limitations to portable alpha have been identified. However. Correlations between alpha managers and their styles are likely to converge or diverge over time. in portable alpha the portions of embedded betas change over time and require a concomitant change to neutralize the beta exposure.Lastly.

Van den Brink (2007) expands upon this view by arguing that also in these new asset classes it becomes hard to speak in alpha and beta terms in these recently new developed investment categories excluding these alpha sources from the portable alpha continuum even in case of derivative coverage. 70 Tom Oor © 2007 .Kung and Pohlman (2004) demonstrate that not all alpha sources are suitable for porting alpha back to the portfolio and thus the continuum of alpha sources found suitable for optimizing the IR at portfolio level is restrained. will a negative alpha in a portable structure magnify the impact. real estate and forestry which have gained interest. If the manager does not succeed in generating alpha or in an insignificant amount. This view. requires to be complemented because liquid markets approaching high levels of market efficiency and are thus found less suitable as alpha source have a liquid derivative market whereas less liquid markets are very suitable for alpha but have less liquid derivative markets. Provided that a portable alpha uses derivatives raising the bar for alpha. however. This is not the case for private equity. Often argued in the context of derivatives that Over-The-Counter (OTC) financial derivatives expose an investor to counter party risk. Another minor issue is the declining utility of a portable alpha versus a regular alpha manager. Whereas in portable alpha the manager solely adds value by the generation of alpha and the materialization of alpha is thus the only utility. the manager still adds value by managing the mandate. A regular alpha manager’s usefulness is the management of the assets in the mandate and the generation of alpha. The source for alpha extraction should have coverage of financial derivatives for detaching alpha and beta. although as Van Iersel (2007) remarks one who does not have confidence in these large banks dealing OTCs should not partake in the financial system.

Apparently. Therefore the relevance of the concept is determined by the dissimilarity in the portfolio investment approaches to optimize the information ratio at the fund level. smaller pension funds adhere strictly to the set asset allocation mix and do not even engage in alpha investing.. which are means to propagate the desired message and not reflect secretive investment policies. The results from the interview with IBM might serve as a testimony for smaller pension funds having lesser resources and thus operating within tighter margins to the asset allocation decision. Van Aalst (2007) refutes the idea that investors abiding by the conventional approach are per se hampered in their quest for alpha and argued that even in the conventional approach pension funds has the ability to employ the entire continuum of alpha sources by simply hedging away the beta risk. The actual discrepancy between the prevailing investment structure and a portable alpha structure in optimizing an alpha portfolio determines the value addition of portable alpha. it remains hard to precisely gauge how the fund operates. pension funds are prudent in disclosing information about their investment policies.7. and thus determine the relevance. This statement remains unclear. the information ratio at portfolio level which is allegedly improbable to be achieved in the conventional approach (Arnott 2002). However. although Van den Brink (2007) provides insight by remarking that pension funds having less knowledge are less likely to operate at the frontiers of knowledge and are thus less likely to deviate from the asset allocation decision.4. 71 Tom Oor © 2007 . Larger pension funds have very little limitations to investment policies and concluding might provide the ability to deviate from the conventional structure. therefore it remains difficult to obtain the exact contrast of the individual approach of the pension fund and the portable alpha approach. i. The applicability of portable alpha depends upon the organizational context of a pension fund The principal benefit of portable alpha is the ability to optimize alpha performance. Even in the form of annual reports. Medium-size pension funds do engage in active investing but adhere strictly to the asset allocation mix.e.

8. the research begins with relating academic research to portable alpha in descending order of abstraction. where it is more talked about than actually implemented. it remains disputable whether subdividing a portfolio into two portfolios with two aims results in an optimal efficient portfolio at aggregate fund level. 72 Tom Oor © 2007 . CONCLUSIONS AND RECOMMENDATIONS This is the point where all the findings of the dissertation converge into conclusions providing an answer to the central question. The conceptual foundation of portable alpha is no novelty and has been around much longer than the first academic publications. However. Empirical evidence demonstrated that at the entire industry level the discussion about portable alpha predominantly gained interest at the larger pension funds. 8. In contrast to the conventional investment approach utilized by pension funds. interviews were held with academics and leading practitioners at investment policies of Dutch pension funds to probe the relevance of portable alpha. investment consultants and Chief Investment Managers of Dutch pension funds. However. the separation of the fund into two investment portfolios enables the fund to optimize the beta portfolio for matching purposes whilst the alpha is used for adding incremental returns. The concept being devoid of a solid academic body of evidence prompted the research to ground the concept in academic evidence. a retrospect is performed upon the research. As a result.1. in recent times the concept has gained in interest amongst asset managers. Subsequently. Conclusions The research endeavoured to reveal the relevance of the applied concept of portable for Dutch pension funds. Based on the findings further recommendations for research are given. portable alpha is a valuable concept to separate a portfolio according alpha and beta investments resulting in the ability to optimize alpha investing in the portfolio by optimizing risk and return. Additionally. Lastly.

73 Tom Oor © 2007 . Nevertheless. in certain asset classes such as timberland. These custodian limitations lay not within the monitoring of financial derivatives but in measuring the changing portions of embedded beta and changing correlation between mandates.The relevance of portable alpha requires to be viewed from the proper perspective. Hence. Financial derivatives are indispensable for decoupling alpha and beta. Principally. are hampering the approach to be relevant for all pension funds. Medium sized pension funds employ custodians to manage their asset mandates. The findings displayed several limitations to the concept. The larger pension funds rich of internal resources to monitor and manage complex investment processes have no difficulty to adopt such an approach and PGGM serves as a testimony. Although these large pension funds are not very representative for the majority of Dutch pension funds. at the actual stance. The smaller category tends not to engage in alpha investing and is also highly unlikely to have the ability to monitor and manage the concept. Although. These custodians are unable to effectively monitor and manage portable alpha. Financial markets not covered by financial derivatives or having an illiquid derivative market in the former case make it impossible to apply portable alpha and in the latter raises the cost and increases roll over risk and spread risk. Alpha appears to add utility by providing incremental returns and the low correlation with beta exposures causing risk to mount lower to return. pension funds tend to be more prudent in the exploitation of alpha and thus limiting the impact that portable alpha could have on the portfolio as a whole. evidence demonstrated that aggregating alpha and beta risk results in total portfolio risk that is much larger than appears. Furthermore. This is due to higher risk aversion applied to alpha investing reducing the utility in portfolio context. The findings demonstrated that the complexities inherent to a portable alpha approach. the concept aims to optimize alpha investing in portfolio context and secondarily provides the ability to construct a beta portfolio for matching purposes. the line between alpha and beta returns is blurred and identification of alpha is a daunting process. even more important. infrastructure and private equity financial derivatives are lacking and thus separation becomes difficult. depending on the real correlation.

these conclusions cumulate in providing an answer to the primary objective of the research: answering the research question: “What is the relevance of portable alpha for Dutch pension funds?” The results demonstrated that tentative conclusions can be drawn and that portable alpha has relevance over the conventional approach. Therefore the pension funds with more organizational resources are likely to deviate from the conventional approach and thus less limited by this sub optimization issue. the relevance for Dutch pension funds is dissimilar amongst pension funds. in the actual stance. (5) Pension funds differ in their organizational resources to support investment policies. (3) However. Smaller pension funds abide stricter by the conventional approach and are also less able to deviate from these policies. although.Finally. This is based upon the following line of reasoning: (1) Portable alpha has the ability to optimize the information ratio in the alpha component of the portfolio whilst attempting to have alpha strategies with the lowest correlation whilst this optimization process is impossible in the conventional approach (2) Portable alpha also could function as a liability driven investment tool in which the beta portfolio matches the assets and the alpha component provides the incremental returns. Provided that the pension fund can identify sustainable alpha performance. the relevance of a portable alpha and beta should be weighed against the possibility of having a sub-optimal total portfolio (4) Investors are prudent with exploiting alpha knowing that the probability that alpha risk will be rewarded is much more unlikely than beta risk and therefore applying a higher risk aversion resulting in a declining utility in the portfolio implying that the place of alpha investing will only represent a small portion of total portfolio assets. 74 Tom Oor © 2007 .

portable alpha is a valuable contribution. Therefore to examine real pension fund investment policies could lead to add or subtract to the relevance of portable alpha. The Research Process in Retrospect The conclusions drawn from the interviewees are skewed towards disproportionate contributions from certain interviewees. i.3. the relevance of the concept and a demonstration of the inherent drawbacks. The results obtained from Van Aalst (2007) have a disproportionate large impact due to his abundant academic 75 Tom Oor © 2007 . The research was unable to conclude whether of a division of entire portfolio into an alpha and beta portfolio results in suboptimal policies. Third. It is improbable to assume that all pension funds either have one of the approaches in the strictest sense. further expansions of the research are given: First. elite bias. A second suggestion for further research is to indulge in the field of portfolio optimization and link the concept to portfolio optimization at the overall fund level. 8. Due to information asymmetry between the researcher and individual pension funds it remains often guesswork what the contrast is between the prevailing investment policy at the pension fund and the contribution of a portable alpha approach. Vetting this would strengthen or undermine the relevance of portable alpha for pension funds.This leads to the contradiction of pension funds with more organizational resources to be more able to implement a portable alpha approach although to be less likely to need it and this is vice versa for the smaller pension funds with less organizational resources. the subjective approach applied lead to the actual stance at Dutch pension funds..2. in a strict comparison between the conventional approach and the portable alpha approach.e. To strengthen these tentative conclusions statistical generalization should follow to examine whether these findings are valid in a wider context. 8. Recommendations for further research Derived from the conclusions which were tentative in nature.

shifted in favour of academic research. the research attempted to have practical as well academic relevance. Nevertheless due to the novelty and the stance in the Dutch industry it is improbable to assume that expanding the sample will result in large deviations from the findings in the dissertation.knowledge. Even though increasing the sample would lead to strengthening the findings this provides no guarantee for interviewees having the ability to contribute to insights on portable alpha. 76 Tom Oor © 2007 . Full theoretical saturation has not been attained. the dissertation resulted in having more academic relevance than practical. in the absence of “perfect “insight in pension fund investment policies it remains difficult to increase practical relevance. practical knowledge ascertaining objectivity whereas Griffioen (2007) has a disproportionate small impact due to his limited knowledge about the concept. Hence. This balance has. although the most important issues have been revealed. as demonstrated by Griffioen (2007). however. Ultimately. As aforesaid.

APPENDICES 77 Tom Oor © 2007 .

........................................................84 Justification for in-depth interviews .............................................................................................82 Research approach .....................................................91 78 Tom Oor © 2007 ...............................................................................................................86 Primary sources ..... Damian Ward BSc MSc PhD (UMIST) 31/05/2007 09/09/2007 Provisional dissertation title: Portable alpha in the Dutch pension fund industry...................90 References ...........................APPENDIX I – Dissertation proposal Name: Program: Supervisor: Date: Submission: Tom Oor MSc in Financial Management Dr.......................................................... Table of Contents Aim ...................................86 Secondary sources .................................................................................................................................. quo vadis? An assessment of its application...............................................86 Provisional table of Contents ....................................................................................................................................81 Scope .......................................79 Research Question: .........85 Data Sources .................................................................................85 Negotiating access ..................................................................................................................................................................................................................................................................79 Objectives .....................................................................................................................................................................................................................................................82 Research method ...........................................................................................................................................................................................................................85 Outcome and Recommendations .......................................................................88 Timetable ...........................82 Research methodology ................... impact and relevance for Dutch pension fund investments..................................................................................................................................79 Personal objectives........................................................................................................................................................................................................................................81 Background ......................................

particularities. these concern the subsequent objectives: • To complete the dissertation not solely meeting the minimum requirements but conforming to the standards for a distinction grade (>70) which is in sync with the overall aim for the program. To explore the extent to which portable alpha might contribute to attain Dutch pension fund investment objectives. the researcher has additional personal objectives which he strives to adhere to during the dissertation and in obtaining the MSc degree in Financial Management. practitioners and academics. To identify the factors associated with determining pension fund investment objectives and to evaluate the impact of these factors on investment policies.Aim To examine the practical relevance for portable alpha and its implications on investment objectives of Dutch pension funds Objectives The research aims to: To investigate the implications. 79 Tom Oor © 2007 . To examine the practical relevance of portable alpha as a methodology at Dutch pension funds for achieving their investment objectives and to examine whether portable alpha has dissimilar practical implications for individual pension funds. Personal objectives Apart from TiasNimbas requirements. difficulties and usages of portable alpha from the viewpoint of investment consultants.

solvency requirements and their implications for investment and in particular asset allocation strategies. • To increase the aptitude for conducting research and developing analytical skills. • To enhance knowledge of investment management. in predominantly in alpha investing.• To enhance his knowledge of the Dutch pension fund environment including the regulatory framework. 80 Tom Oor © 2007 .

However. the myriad of publications and the large number of consulting firms offering services around portable alpha serves as a testimony for the traction it has gained amongst business practices. is not substantiated by an extensive body of academic research. benefits and drawbacks of Portable Alpha. a consensus about portable alpha has not yet been attained. These phenomena have forced pension funds to embrace liability driven 81 Tom Oor © 2007 . Fung and Hsieh (2004) discuss the conduciveness of long/short hedge funds as a source of extracting alpha for portable alpha. nevertheless tend to remain on the surface. Arnott (2002) manifests how portable alpha contributes to curbing risk by decoupling active management from passive management resulting in the ability to rebalance asset allocation to the desired risk position. Thirdly. Recent developments in Dutch accounting rules and regulatory requirements have further narrowed down the scope for risk tolerance and investment possibilities. vetting the notion of portable alpha. Kung and Pullman (2004) are one of the rare few who discuss the processes. the proliferation of conferences on portable alpha.Research Question What is the relevance of portable alpha for Dutch pension fund investments? Background There are four principal reasons for the subject of the dissertation. much of the work to date is targeted at a practitioner audience and though intuitively appealing. First. Academics have forayed into the field of portable alpha but academic research related to the subject remains in its infancy. portable alpha has gained momentum amongst institutional investors due to its appealing features of providing leeway to asset allocation whilst generating alpha from other sources. The dichotomy of business practices paired with the lack of substantial academic literature adds to the relevance of the subject. Business practices and their stances on portable alpha are roughly subdivided into two camps: the sceptics questioning the elusiveness of alpha itself and those who are beholding an incrementing implementation amongst institutional investors. Secondly. and thus supporting the relevance of the concept.

OECD 2006). Scope Geographically. empirical research in the form of interviews focuses solely on internal and external pension fund investment advisors located domestically. Furthermore the industry has a wide range of pension funds differing in size. in particularly larger ones. Nonetheless harmonizing liabilities with fixed income or index linked bonds reduce exposure to interest rates and inflation but do not yield the returns to pay pensions. The scope for investigating the relevance of portable alpha emphasis disproportionately on a qualitative point of perspective and quantitative information is used to validate the impacts of portable alpha upon investment objectives. Dutch pension funds have the largest relative amount invested in the world. Portable alpha has become the panacea for adhering to these stringent accounting and regulatory rules and the ability to yield returns to pay pensions (FT Mandate 2006).investment (LDI) by investing in financial assets that matches their liabilities (Pensioen. the Netherlands with its well developed pension fund structure and strict legislative framework might be a proper setting to explore the relevance of portable alpha. might obtain advice about their investment policies from foreign advisors. measured in terms of percentage of domestic GDP (OECD 2006). Such a wide variety of pension funds and their different investment policies subject to strict legislation is purposeful for analysing portable alpha from a wider perspective. Pension funds.en Verzekeringskamer 2004. maturity of obligations and pension plan payments. Fourthly. it would be worthwhile to investigate if portable alpha could contribute to such an intricate investment environment. Research methodology Research approach 82 Tom Oor © 2007 . the research will be limited to the inclusion of pension funds that are Dutch and thus subject to the Dutch regulatory framework. Hence.

depriving a deductive approach from forming a solid academic framework for hypothesis testing. Even more important for an inductive approach. It attempts to find new insights and assess the phenomena of portable alpha from a pension fund stance. the benefits of gaining an insight in a complex and dynamic process outweigh the biases that might impede the repeatability of the research process. Nonetheless. In function of the research question and the scarcity of academic literature. an inductive approach is preferred. Conducting a qualitative approach places the results in a situation where it will be difficult to make generalisations about the entire population and an iterative process does not necessarily leads to the same results (Yin 1994. The emphasis of the dissertation is not so much on deducting hypothesis from a theoretic framework and exploring causal relationships between predetermined variables but more on finding explanations for the practical relevance of portable alpha in meeting pension funds investment objectives. 83 Tom Oor © 2007 . cited by Saunders 2003). an analysis of the practical relevance of portable alpha is entrenched with human factors which can’t be detached from the concept in exploring if such a process might be applicable and valuable for a pension fund.The purpose of the dissertation is to identify the relevance of portable alpha for Dutch pension fund investment objectives.

Qualitative interviews are susceptible for biases.Research method 1. The literature review will cover all relevant material and sources of information disclosed in the reference list. pension fund investment objectives including a minor digression on the regulating framework determining pension fund investment objectives. Secondary sources The literature review in the case of analysing portable alpha has been proven not to be comprehensive and the lion’s share of information about the topic is available in secondary data. although validity of these sources is questioned. therefore the researcher will attempt to prepare himself according Saunders et al (2003:254) guidelines to minimize biases in the interviews. 2. The interviews will be semistructured and will have an exploratory nature and are divided into: • • Interviews with Chief Investment Officers (CIO) of pension funds Interviews with external investment consultants 84 Tom Oor © 2007 . 3. cited by Saunders) in depth interviews might be purposeful in finding out what is occurring and to gain new insights in a phenomenon. Interviews A qualitative approach in the form of in-dept interviews with industry experts will be used to reveal the extent of relevance of portable alpha and how its impact on investment performance. The aim of secondary data is to facilitate a rough image of portable alpha and investment policies at Dutch pension funds for structuring semi-structured in-depth interviews. a literature review will be performed on the different stances on portable alpha. As Robson states (2002:59. Literature Review First of all.

Justification for in-depth interviews

Theoretically speaking portable alpha appears to be a valuable process for a pension fund but the main research focuses on the practical aspects of portable alpha for pension funds. It’s therefore essential to understand the reasons and attitudes towards portable alpha by the decision makers in the process. Another issue which should not be neglected is the more receptive approach of managers towards interviews in comparison to questionnaires. Industry participants are more willing to reflect on events than writing them down (Saunders et al 2003).

Negotiating access

The success of the research method depends heavily upon gaining access to the appropriate sources, in this case to access pension fund CIO’s and external consultants. According Easterby-Smith et al (2002) to gain access is most successful where an acquaintance works in the organization. The researcher has support from a close relative occupying a position on the board of “het Actuarieel Genootschap” (Dutch institute of actuaries) and as a senior partner at Watson Wyatt in the Netherlands. This might take away impediments to access the desired sources by making use of his extensive network. In addition, the required information does not concern sensitive information and hence might overcome reluctance of interviewees to participate.

Outcome and Recommendations

The dissertation should result in an appraisal of portable alpha in a Dutch pension fund context; until what extent portable alpha contributes to Dutch pension fund investment objectives, what is the practical relevance of the methodology for the industry and how pension funds with distinct investment goals and capabilities compare. Ensuing, the dissertation should cumulate in recommending areas for future research and plead for best practices of portable alpha. These recommendations are not intended to be exhaustive as the analysis undoubtedly exhibits a degree of bias inherent to a qualitative methodology.

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Data Sources

Primary sources

Interviews with Chief Investment Officers about the usage, the difficulties and the effects of portable alpha on investment decisions

Interviews with external investment consultants about the usage, the difficulties and the implementation of portable alpha

Secondary sources


Fabozzi, F., J. (1996). Pension Fund Investment Management. New Jersey: John Wiley & Sons, Inc.

Warwick, B. (2000). Searching for ALPHA: The Quest for Exceptional Investment Performance. New Jersey: John Wiley & Sons, Inc.

Journal publications

• • • • •

Portable alpha Alpha investment Asset allocation Pension fund finance Investment management

Annual Reports (Pension fund disclosures about their investment policies)

Internet sources

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E.g. Publications of the Organization for Economic and Cooperation Development (OECD), Pension & Investments, European Pensions & Investment News, De Nederlandsche Bank, Pensioen-en Verzekeringskamer, Morgan Stanley journal of Investment Management, Nederlands Pensioen en Beleggingsnieuws.

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4.3.Literature Review 4.4.1 Introduction 2.3 Investment objectives 3.3 Validity 3.3 Interview design 2.2 Secondary Research 2.4.4 Credibility of the Research methodology 2.3.2 Aim 1.3.1 Nieuw Financieel Toetsingskader Part II . Alpha investing 4.5 Scope 2. Pension fund Finance 3.4 Recent and expected developments 3.3.3 Primary Research 2.1 Philosophical stance 2.1 The notion Alpha 88 Tom Oor © 2007 .4. Research Methods 2.2 Reliability 2.1 The Dutch pension fund industry 3.4 Objectives 1.3 Central Question 1.2 Research method 2.Provisional table of Contents Part I – Introduction 1.3.1 Limitations 2.2 The regulatory framework 3.1 Background 1. Overview 1.3.3.

1 Investment policy 6.1 The process 5. 8.4 The alleged benefits 5.1 To what extent have the dissertations objectives been met? 9.3 Portable alpha sources and its implications 5.2 Sources of portable alpha 5.5 The challenges 6.3 Alpha generation 5. Portable Alpha 5. Pension fund investment 6.2 Managing the asset mix Part III – Research Analysis 7. 9. Conclusion and Recommendations 10.2 Consistent out performance of the market 4. Analysis of internal investment managers’ interviews Analysis of external investment managers’ interviews Discussion 9.1 Conclusion 10.4.2 Do the secondary and primary sources coincide? 10.2 Recommendations on further research 89 Tom Oor © 2007 .

portable alpha Literature review .3 10 Dissertation proposal Read literature Examine Dutch pension fund industry Finalise objectives Draft objectives Literature review . Gantt chart Dissertation proposal Tom Oor 90 Tom Oor © 2007 .external Conduct interviews . copying and binding Submit dissertation Figure 1.Internal Analysis of interview data Draft interview analysis Write dissertation (Finalise) Draft dissertation Proof reading Final edit.alpha investing Literature review .Pension fund investment objectives Draft literature review Devise research approach Draft research strategy & method Conduct interviews .Timetable Time Activity July June 2 9 16 23 May 4 11 18 30 25 21 28 + + + + x + + + + + x + x + + + x + + + x + + + August 6 13 20 27 Sept .

no. MSc course syllabus.. J. L. Vol. (2002) Management Research: An introduction. Journal of Investing. 78 -87. No. (2005). R. (2004). M. 2. J. Graduate School of Management. (2004). New Jersey: John Wiley & Sons. (2006). and Hsieh. New Jersey: John Wiley & Sons. and Baumgartner. pp. C.. 91 Tom Oor © 2007 .. Vol. D. Journal of Investment Management. Funga. and Lowe. 2. Morgan Stanley Journal of Investment Management. Neville. Vol. 2004. J. 15-22. 2. pp. 2. NIMBAS University. 30. J. and Pohlman. B. R. (2005). [online] http://www. Process & Performance. D. Transportation and Recombination. 1-8 Coates.. May 2005. Pension Fund Investment Management. Loftus. 1. pp. Inc. Pension Finance. J. no. M. 2. No. Keller. (2006). D. (1996). and Moore.. Fabozzi. Thorpe. London: Sage. Portable Alpha – Philosophy. J. pp. 3.htm [Accessed 12/05/2007] Coates. Alpha-Beta: Separation. Vol. Pimco publication. 2nd edition. Extracting Portable Alphas from Equity Long/Short Hedge Funds. Morgan Stanley Journal of Investment Management... pp. Vol. F.com/LeftNav/Viewpoints/2005/Alpha+Beta. 11. 27-36 Easterby-Smith. Brittain. no. Pitfalls and Risks in Portable Alpha Implementations.pimco. Effective Learning Service: Introduction to Research. (2002). (2004). Inc. W. Asset-liability Risks and Portable Alpha. E. 4.References Arnott. Journal of Portfolio Management. A. Blake. 1–19 Kung. Risk Budgeting and Portable Alpha. A.

(2000).dnb. Inc. New Jersey: John Wiley & Sons. 3rd edition. October 2004 [online] http://www. Harlow: Financial Times Prentice Hall.pdf [Accessed 22/05/2007] Saunders.en Verzekeringskamer (2004) Consultatiedocument Financieel Toetsingskader. 92 Tom Oor © 2007 .oecd.org/dataoecd/21/28/37528620. Searching for ALPHA: The Quest for Exceptional Investment Performance. issue 3. Research Methods for Business Students. B. P. A.. and Thornhill. October 2006. (2003). Lewis. Warwick.. http://www. M.OECD: Organisation for Economic Cooperation and Development (2006) Pension markets in focus.pdf [Accessed online 23/05/2007] Pensioen.nl/dnb/home/file/Consultatiedocument_tcm46-145152.

Manager Selection and implementation of investment policies. Currently he occupies the position of external management taking care of external alpha managers. Roland van den Brink joined the board of directors at MN services. as partner of Strategeon Investment Consultancy Ltd. PGGM is the second largest pension fund in the Netherlands having approximately 80 billion of pension fund assets under management. Interviewee Wim van Iersel is employed at SPF Beheer which is a large asset manager having 14 billion of assets under management. pension funds about Asset-Liability Management.APPENDIX II – Profiles Interviewees Interviewee Paul van Aalst commenced his career at the Erasmus University in Rotterdam teaching Finance and Investments. he has been director investments at PME disposing over 19 billion in assets. Since 2003 he advises. He used to be employed there as manager shares and private equity. as managing director of investment consulting. Afterwards he moved to the Robeco Group in the job as researcher. Furthermore. Interviewee Roland van den Brink is chairman at the actuarial society in the Netherlands.. Interviewee Rijk Griffioen is employed at the IBM pension fund where he manages the investment policies. 93 Tom Oor © 2007 . Interviewee Jelle Beenen is employed at PGGM where he manages the portfolio of strategies. Jelle Beenen mainly manages the task of exotica beta. Simultaneously he recommenced teaching at the University of Amsterdam. Furthermore does PGGM its own investment and has its own dealing room. he worked at Brans & Co. Recently PME merged with MN services resulting in an asset manager in the Netherlands having 58 billion under management. Consequently.

he notes that almost all pension funds belief that active investing can add value to their portfolios. the eternal discussion remains sustainable alpha. although markets could be placed on a continuum of their degree of inefficiency. In contrast to the equity component in the active portfolio.APPENDIX III . Sustainable Alpha He also emphasized that although market inefficiencies are present. He illustrates that stances on inefficient markets and thus the ability to pursue active management are widely debated and even the academic literature is not straightforward in answering this question. Until the 1980s most academics were brought up with Fama’s (1970) Efficient Market Hypothesis (EMH) and thus convinced that active management could add no value. he believes that interest rates shift can fairly well predicted in the medium term and thus active management could add value. His belief was that there were regional differences in state of market efficiency and the expectance was that the most inefficient markets were in the east (Asia) and the most efficient markets in the United States. 94 Tom Oor © 2007 . Contrary to his opinion. Sustainable alpha remains in many cases disappointing and critical examinations of these alphas shows that these alphas are from sustainable and thus there remains not much to port back to the portfolio. The remark goes that pension funds are not yet optimizing or using sufficiently bonds in their active portfolio where they should and this will become more and more valuable due to the requirements of the FTK.Elite in-depth interview results Findings Interview I – Paul van Aalst Active investing The interviewee argues that markets were non efficient in the strictest sense. He believes that within these confines the possibility for alpha is present although he remains rather sceptic about the value addition of alpha in an equity context.

This has triggered cynicism at pension funds about new investment concepts. The incubation time between concept and factual application is a justified and long process to ponder about the drawbacks in the portable alpha concept. For illustration purposes.Alpha contribution The relevance of active investing was put in proper context by arguing that the return of a portfolio could be globally explained by 70% through your asset allocation decision. 20% which countries and markets were included in this mix and 10% by active investing. This gap between concept and application is not necessarily cumbersome. which concepts are really relevant for pension funds. He argued that therefore the contribution of active investing usually occurs within the last decisions to be taken and also have a small impact on overall portfolio performance.e. The interviewee argues that the vetting and development of concepts such as portable alpha are driven by the interaction between academics and professionals.. he shows the incubation time between Markowitz’s portfolio theory (1958/1952) and the first commercial application (1984). i. 95 Tom Oor © 2007 . it become to difficult for pension funds to separate the wheat from the chaff. although as he illustrates in a pension fund context these small impacts could easily translate themselves in billions. In such a context. The conceptualization of portable alpha is especially driven from the professional side as academics are brought up with Fama’s EMH and thus have an aversion for rejecting his hypotheses. Portable Alpha The concept of portable alpha is not a widely debated topic at pension funds and the discussion remains predominantly at the top tier Dutch pension funds (20/30 largest) and even there it is more talked about than implemented. Separating the wheat from the chaff The other impediment to the proliferation of portable alpha arises in the supply side. The enterprises supplying portable alpha promote this concept in such a manner pretending much more under the pretext of portable alpha than would be reasonable to assume.

Changing the mindset The interviewee argued that a portable alpha approach requires a radical shift in mindset for the pension fund trustees. Until recently the majority of the pension funds found themselves in situations in which their funding ratio reached 100% – 105% in such a case pension funds had no option than to invest everything in their beta portfolio for matching purposes because the value of their assets were just a little bit more than their financial obligations. The asset allocation argument The interviewee sees the point in which the asset allocation could limit the quest for alpha. one should question himself. it would be sensible to include all assets in a beta portfolio at times of low funding ratios. The interviewee argues that this is not a grave issue and that there are more issues in which we operate in an inefficient way because dealing with an optimized portfolio can be very difficult to manage. It would be unfair to implement a portable alpha strategy whilst these trustees have a difficult time either to understand the concept but also to see the relevance of the concept. Therefore. if it would be sensible to separate an investment portfolio in a beta and alpha part. Total portfolio separation The separation of a portfolio in an alpha and beta component is contingent upon the starting position of a pension fund’s funding ratio. a theoretical perspective is demonstrated that one could argue that the separation of a portfolio into two efficient sub portfolios seldom results in an entire efficient portfolio. if only a very small part is left over for alpha investing? Will it be worth the effort to actively manage such a small part of the portfolio? From a cost efficiency point of perspective. From. Therefore he argues that one should be aware of making the trade-off by sub-optimizing the risk/return trade off of the portfolio versus the facility to manage the portfolio. These pension fund trustees are ultimately held responsible for the management of the fund and therefore have to be comfort with such a change. although he argues that this should not per se be a limitation and that it depends 96 Tom Oor © 2007 .

In case of a portable alpha concept. Portable alpha expectations The interviewee expresses that he finds that these portable alpha concepts or enterprises promoting these practices are arousing to high expectation which are unlikely to be realized. The interviewee explains that these pension funds use custodians to monitor asset managers. In the traditional structure. The inability to manage a portable alpha concept The argument goes that these new concepts such as portable alpha might be applicable for the Dutch pension giants such as ABP and PGGM. Even in the classical approach it would be possible to select a manager for his alpha and hedge away his beta exposure. In such a case. 97 Tom Oor © 2007 .upon your organization. although this often is in conflict with the mindset of the pension fund trustees who have difficulties with the portable alpha concept of obtaining passive exposure in one asset classes and extracting alpha from another asset class. the value addition of a manager is only his alpha contribution if he yields no alpha than there is no value addition. Alpha value addition In a portable alpha context. although for the additional 690 with fewer capacities monitoring such concepts would remain cumbersome. the issues of monitoring beta exposure and hedging away beta exposure has to be done at these custodians which are only limited in numbers. The lion’s share of these custodians in the Dutch but also in the States is unable to monitor such a process. if an active manager generates no alpha this is not such an issue because the foremost reason is his part of the portfolio. Apparently here the interviewee makes the confusion of applying the possibilities made possible by a portable alpha approach in the conventional structure. it would be possible. The responsibility lies therefore at these custodians to monitor these investment mandates for these pension funds.

almost the entire portfolio would be required to match assets due to the low funding levels. in such a context the eternal aim is to maximize the return for a given tracking error as the interviewee endorsed. These portable alpha mandates will be externally implemented by managers with very high tracking errors but absolutely low correlation. To complement this traditional approach of filling the asset class mixes with the best managers. Management therefore has decided to have a larger opportunity portfolio. Of course. The interviewee argues that with higher funding levels there are more possibilities to form an active portfolio with (prospective) higher alpha’s and information ratios (IR). funding levels have a much better level. portable alpha mandates are added to the portfolio.Findings Interview II – Wim van Iersel Optimizing risk budget The interviewee explains that the pension fund is seeking to optimize its active risk budget. although of course the risk of surpassing the funding level of 130% has been taken into consideration. Funding level The funding level of the two largest pension fund assets under management is respectively 140% and 180% and therefore provides the occasion to employ a more aggressive active risk budget. At the actual stance. Alpha profile The largest portion of active risk is taken in the equity part of the portfolio 98 Tom Oor © 2007 . The interviewee describes that they are trying to find the best managers within their asset allocation mix and to optimize the allowed tracking errors with active performance. This should lead to a more optimal active risk/return portfolio. In retrospect to a few years ago.

The interviewee remarks that the active manager could also have a temporal deviation due to specific events and in addition he remarks that markets do not become efficient over night. the investment style and his degree of consistency. especially in a context of finding non-correlated managers. Although. Although such decisions require time to be drawn and such conclusions usually require 3 to 6 months to make a proper judgment. the pension fund abides by long only strategies. the legal contracts between the fund and the active manager are formulated in such a way to act promptly if an active manager deviates from its style or performs unwanted actions. The interviewee however endorses that does not lead to optimal active portfolio. the interviewee warns: “would it be valid to assume extrapolation of his past results? “ In addition. The investment process analysis compasses the past results of the manager in question. In fact.Active management: identifying good managers The interviewee endorses that it’s difficult to identify proper managers. Also. SPF has subdivided its portfolio already in an alpha and beta component by its organizational structure in 99 Tom Oor © 2007 . Portfolio Separation The interviewee would not be astonished to see the division of the portfolio into an alpha and beta component in 3 to 5 years. Short constraint Actually. In such a case the beta portfolio would be purely held for matching the assets and liabilities and the selection of managers for their alpha in which pairing the two will occur by swaps. The pension fund has been looking for the implementation for 130/30 strategies although the trustees are not yet so far to make this decision. The interviewee explains that with the time these constraints will be abolished to make optimal use of alpha within your existing risk budget. he remarks that it’s not only based on hard facts and that the selection process also is based on gut feeling and the trust one has in a manager. The process of identifying active managers is usually based upon the rationale behind the investment process and a portion of gut feeling about a manager.

However. The employment of strategies with higher information rations. The interviewee argues that he would be pro such a portfolio separation.which the interviewee manages the external components and another manager the internal products. the greater part of the portfolio remains in the matching portfolio. Alpha scarcity The interviewee agrees that if the entire industry commences to search for alpha niches it turns into a commodity with the accompanying risk/return profile. as an ever increasing number of investors jump on the portable alpha bandwagon it is likely to become scarce with all its consequences. Therefore for the return portfolio to have an impact on the total portfolio large alphas are required. The interviewee is not capable to confirm whether such a separation of a portfolio results in a suboptimal total portfolio. he opines that bear markets are characterized by a larger extent of extremes providing more opportunities for alpha and thus portable alpha. He admits that there had been a discussion about such and with the board last year. Alpha aggressiveness Even in a case of lower risk of underfunding.3 and 0. This is definitely a limitation for portable alpha. However.8. A bull market phenomenon The interviewee argues that portable alpha is not a mere bull market phenomenon. The interviewee finds it reasonable to exploit IR between 0. the organization was not yet ready to absorb such a change. 100 Tom Oor © 2007 . a higher degree of disappointment can be expected since these high IR are unlikely to remain sustainable for long. His argument is based upon the notion that both bull and bear markets provide excess returns which from a theoretical perspective should make no difference in yielding alpha.

He remarks that financial markets are dynamic and therefore always changing and never in states of equilibrium but more likely to be in the process of convergence or divergence. you create another problem by requiring a benchmark to measure performance. The interviewee questions the benchmark. the pension fund is a long term investor and hedge funds are considered short term investments. Hence an investor starts investing conform a benchmark and this philosophy impacts your investment performance by thinking that investing conform the benchmark is without risk. He argues that beta is inexpensive and gives the example that for approximately 3 basic points on can invest in indices.Sourcing alpha from a hedge fund The pension fund direction has no interest in absorbing hedge funds in the asset mix. Secondly. Their arguments are based on the following way of reasoning: first. The belief in alpha The interviewee believes in alpha investing. a lack of transparency paired with relative high costs and low returns does not appeal to the pension fund. Also with thinking in alpha and beta terms. Asset allocation decision The interviewee also puts active investing in perspective by arguing that active investing is usually the last decision to take in the investment decision process. 101 Tom Oor © 2007 . In the process of converging managers with the right skills should be able to add value through alpha investing. He argues that therefore more and more is outsourced to external managers to be able to focus on what really matters being in the right asset classes and matching assets and liabilities (β exposure) Findings Interview III – Roland van den Brink Alpha concept The interviewee is very sceptic about the term alpha and opines that it is made up by the industry. His opinion is that therefore for the industry to make some money the term alpha is created.

Prudence in Alpha investing The interviewee quotes the pension fund database of Ambachtsheer. The database demonstrates that pension funds that are prudent with taking active risk (80% passive/ 20% active) have an average better performance than pension funds who have a different approach (insinuating a higher percentage investing in active management). He argues that the difference is due to the costs of active investing and that alpha investing is really an art which does not come falling down out of heaven. Therefore one should be very prudent with taking positions.

New investment opportunities Recently, new investment possibilities have arisen such as infrastructure, industrial timberland (CMA), life settlements and CAT bonds. Someone investing from the beginning with skill in such new opportunities should this be considered as alpha or beta? Investors entering the market usually have a first mover advantage although should this be considered alpha or beta? These relative new markets market under development in which it becomes difficult to speak in terms of alpha and beta because there is no beta. Also foreign exchange (FX) markets have no beta market and can’t be related to a beta market; there is no index. The interviewee argues that FX is one of the most consistent sources of alpha and this is already a kind of natural portable alpha product.

Portable alpha The interviewee sees the portable alpha concept more as a marketing product conceptualized by the industry with no value. He argues that a pension fund has the ability to implement a portable alpha construct by them without needing a portable alpha mandate. He does not need to obtain alpha from one category of assets and port it to another category, this can totally be done by the pension fund self.

Portable alpha skills The interviewee agrees that he has portable alpha mandates in his portfolio. He argues that this is not for reasons of the structure but more for the skills the manager has.

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These skills the particular manager has are of importance and would be otherwise unobtainable.

The investment products industry The investment industry is very successful in the attempt to anew develop products in way to make profits. Investment structures have not changed that much and it is more the industry’s attempt to repackage old concepts to generate fees. Therefore, it is likely to be a contemporary phenomenon directed by sales teams from the investment industry. Asset allocation restriction The interviewee explains that the larger pension funds are not limited by putting their asset allocation decision first. Although, this does apply for the medium-sized pension funds having less knowledge about investment and operate less at the frontiers of investment practices. At these pension funds one has to operate within the asset allocation decision and there is where portable alpha is mostly used. The smallest category of pension funds does not even operate within the field of active management. Larger pension funds make use of derivatives since the beginning and are permitted to do so. For the medium size pension funds the uses of derivatives is often limited and therefore use hedge funds as a way to circumvent the derivative constraint. He illustrates here again that he does not need hedge funds because the pension fund is capable to structure these investment techniques by themselves but the fund of course might be willing to hire someone who can do the job better (skill).

The portable alpha structure The structure of portable alpha is according the interviewee has more relevance for the medium size pension fund as these need portable alpha structures to be able to source from different markets. Portable alpha makes it therefore possible for them to access these markets which conventional would not be possible.

Portfolio separation

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This is a change from thinking in asset classes to thinking in terms of skill. This would be an efficient approach by optimizing the use of skill. The management of beta and alpha requires different capacities. In the conventional asset allocation approach, the combination of skills are made which are not inherent in a person whilst separating in terms of skills it is possible to attain higher levels of specialise.

Findings Interview IV – Jelle Beenen
Conventional versus portable alpha approach The interviewee makes the contrast between the traditional approaches. He demonstrates that a long term asset mix is determined and within this mix tracking errors are allowed for active performance. These tracking errors are set within the long-term asset allocation decision and therefore alpha is generated within this decision. In the new PGGM structure (a separated alpha and beta portfolio) is a portable alpha approach becomes redundant. In this structure the alpha portfolio has been given a risk budget for alpha sources and they are free to choose where to obtain alpha. Such a portfolio structure also provides the ability to take cross asset bets whereas in the conventional structure this would not be possible.

Suboptimal entire portfolio The interviewee demonstrates that such a portfolio might result in inefficient behaviour. For example, if the beta department buys a certain index to track whereas the alpha department sells the same index at the same time for another reason. This increases cost. However there is also coordination between the two portfolios reducing costs and harmonizing portfolios.

Portfolio returns The strategic asset allocation is the most important decision. The alpha is additional but not unimportant. The interviewee tells that the strategic mix determines whether the results will be scattered around 5%, 9% or 12% and the alpha will add 1 or 2%.

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According the 105 Tom Oor © 2007 . Another limitation argued by the interviewee is that it is impossible to invest a substantial size of the portfolio in alpha. A portable alpha strategy requires a lot of knowledge which is currently not internally available and therefore the pension fund is more restricted to traditional asset classes and a more simplistic investment approach. Findings Interview V – Rijk Griffioen The pension fund board The pension fund board bears responsibility for the investment results and policies of the pension fund. although in practice this is much harder to measure and implement. Overlay execution The interviewee endorsed that derivatives are used in the actual portfolio.This might appear unimportant but 1% or 2% additional return long term results in 25% less payments for the pension fund participants. A custodian is used to effectively monitor the usage of derivatives. especially for PGGM. They ultimately determine the investment policies used and the direction of future investment policies. Alpha in bear markets The interviewee argues that it is more difficult to make alpha in bear markets. Measuring correlations of alpha managers From an academic point of perspective this all very valid. The interviewee demonstrated that the pension fund board was not yet ready to embrace an investment strategy as portable alpha and that currently the pension fund is contemplating change in investment policies such as an alternative investment portfolio. The pension fund committee is totally comfortable with using these in investment strategies.

106 Tom Oor © 2007 . The interviewee argued that alpha in such a case might not be the most important contributor to the portfolio. Risico budget The interviewee demonstrated that determining the risk budget was similar to a back of the envelope calculation. Funding ratio The pension fund is currently having a funding ratio of approximately 170%.interviewee a custodian has no difficulty whatsoever the monitor the use of derivatives.

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