The Pennsylvania State Employees’ Retirement System these days is the poster child for a once-compelling idea that’s not so compelling anymore: portable alpha.
Constructed under the direction of Norwalk, Connecticut–based consulting firm Rocaton Investment Advisors, PennSERS’ portable alpha scheme, which combines funds of hedge funds with derivative contracts on broad market indexes, has tanked of late because, in short, the strategy doesn’t work in broad market downturns. Promoters of portable alpha sell it as a way to juice returns on plain-vanilla index funds. Once the darling of cutting-edge consultants and their devotees, the strategy uses derivatives — swaps or futures — to buy index returns rather than index-fund securities. The cash that is freed up as a result is then invested, often in hedge funds, whose alpha is “ported” onto the market-index returns.
Harrisburg-based PennSERS, which ranks first among state pension systems in the size of its hedge-fund allocation, ran into trouble with its portable alpha when all three of its components — the markets, the swaps and the hedge fund returns — fell in the third quarter of 2008. The portable alpha program last saw black ink in June, with a 2.8 percent return for the first half of the year. PennSERS had to pay counterparties some $2.5 billion this year from its $9.1 billion hedge fund portfolio for losses on the swap contracts. Pension plan officials estimate that if the markets continue to drop, the fund — whose overall value now stands at $27 billion, down from $35 billion in July 2007 — may lose an additional $1 billion. They note, however, that since inception, the portable alpha scheme has made about $500 million.
PennSERS made its first hedge fund investment in 1999, with four market-neutral funds. When these proved too closely correlated, it began looking at funds of funds and in 2002 hired Blackstone Alternative Asset Management. The following year it launched the portable alpha program. The idea was to use hedge funds to generate alpha — pure positive returns above what it could get by investing in the broad market — and then add that to the market return created by using swap contracts on the Standard & Poor’s 500 index and later the MSCI Europe, Australasia and Far East index. The strategy worked for a while, beating returns on the U.S. equity market by, on average, 6.2 percentage points a year. But through October, the program was down 55 percent on the year.
Sandy Urie, CEO and president of Boston-based Cambridge Associates, does not recommend portable alpha to any of the firm’s almost 900 clients. “It’s hard to find sustainable alpha and difficult to implement,” Urie says.
Some consultants argue even more emphatically against it. “You are crushed — losses on top of losses,” when portable alpha goes bad, explains Michael Rosen, CIO of Angeles Investment Advisors in Santa Monica, California, noting that losses can come from three directions: hedge funds, market indexes and derivative overlays. Jim Vos, CEO of New York–based consulting firm Aksia, talked the School Employees Retirement System of Ohio out of a move into portable alpha in September. Consultants at Segal Co. in New York put an October 1 portable alpha program on hold at the International Association of Machinists and Aerospace Workers’ national pension fund. Just before he left PennSERS, at the end of July 2007, former chief investment officer Peter Gilbert began to pull back on the PennSERS portable alpha scheme. Under his successor, John Winchester, the program still has about $5.2 billion in assets. Rocaton, which did not respond to repeated requests for comment, had its PennSERS contract renewed in July.
