Managing assets via "alpha": an expert in asset management explores a special technique—"Alpha Transfer"—that amounts to a form of telecommuting for excess returns. Here's how it works

Risk & Insurance, June, 2002 by Andrew P. Hofer

Uses in Tactical Management

Just as an investor looks at differing asset classes and sees the mismatch between asset class returns and alpha potential, the active manager sees the same sort of discrepancies in sectors of their markets. Managers can use alpha transfer techniques as an active management tool just like investors may use it as a strategic tool.

For example, my firm manages a lot of short duration fixed income investments. By definition, these "liquidity" clients want to minimize interest rate risk in their portfolios. Restricting the portfolio to short-duration investments, however, constrains portfolio managers from accessing the higher alpha opportunities available in longer duration securities. Chart Two (directly above) depicts our ex ante return and information ratio expectations for corporate debt (represented by LIBOR) vs. treasuries as of March 19, 2002.

As you can see, we forecast the highest excess return potential at the three-year part of the yield curve. In addition, we foresee this higher return potential coming at a relatively low level of risk, marked by the high information ratio at that point. In a short duration portfolio, however, we are limited as to how much three-year paper we can purchase without exceeding the portfolio guidelines. When the peak of this curve is at five or seven years, the mismatch is even more acute.

Our solution is to purchase the longer corporate notes, but then use an interest rate swap or treasury futures position to adjust the interest rate sensitivity of the portfolio to the target duration. In this way, we are able to "carry" alpha opportunities outside of the portfolio's natural long market into a portfolio that still behaves like its benchmark.

The Future

Alpha transfer techniques are not new, as demonstrated above, but they are hardly ubiquitous. As investors become more comfortable with derivatives and managers develop systems to exploit cross-market excess return opportunities, alpha transfer techniques should become more prevalent. That trend holds promising possibilities:

* Investors will gain additional flexibility and control to manage risk and return. They will increasingly be able to separate the asset allocation decision from the selection and supervision of their active money managers. It will be possible for clients to give more funds to consistent alpha producers even if they are reducing their strategic exposure to that asset class. Larger investors will be able to align their asset allocation strategy over the whole portfolio to their long-term return goals while allocating funds to managers with greater alpha potential.

* Within asset classes, managers may increasingly be able to achieve consistent returns, even in environments where intrinsic alpha opportunities are small.

Nonetheless, a number of obstacles remain:

* Costs, liquidity and supply/demand imbalances within the derivative markets vary dramatically, so alpha transfer opportunities are not always stable. At present, one's ability to exchange return streams varies widely from one market to the next.