How investors can access fairly-priced ‘portable alpha’ strategies

In 2024, equities had another year of strong returns, particularly the US markets, building on the positive performances of the last decade. Yet despite the tailwinds from markets, investors likely still find themselves disappointed in their active equity allocations.

Unfortunately for active managers, the largest stocks drove much of the market’s performance throughout 2024, leaving them in a virtually unwinnable scenario: either underweight the largest names and likely underperform, or concentrate in the market’s largest holdings and potentially exceed risk targets.

Last year was likely a continuation of the past decade’s trend, over which the median active equity manager delivered approximately zero value-add in the US and internationally. The active return of even top-quartile managers has been only 0.4% in the US and barely surpassed 1% internationally, when looking at trailing 10-year annualised active returns ending 30 September 2024 among the eVestment US and EAFE large-cap equities universes, respectively.

More concerning than 2024’s performance are the risks that lie ahead for traditional active equity management. It is high time for investors to consider a different approach to incorporating alpha within their equity allocations — portable alpha.

The problems: elevated equity valuations and macro volatility

The downside of equities’ exceptional performance over the last decade is highly stretched valuations, with Shiller’s PE ratio at 36.4 as of writing, in the 97th percentile versus history. Even assuming above-average fundamental growth, base case expected returns for equities over the next 5 to 10 years are still below average: an expected real return of 3.8% for US equities as of December 31, 2023, according to AQR’s forecasts.

Global macroeconomic volatility is also elevated, as major economies face both inflation and unemployment risks, leading to many possible macroeconomic scenarios. Additionally, central banks are far more constrained than they were in the 2010s, as they face meaningful trade-offs in supporting their employment and inflation mandates.

Layered on top of fundamental economic risks are numerous geopolitical factors, such as US domestic and foreign policy uncertainty and multiple hot/cold wars around the world. This leaves long-only portfolios exposed, as equities historically have not performed well in times of heightened macro risks.

Investors, in theory, should be considering long/short diversifiers in an environment like this. However, many investor benchmarks include exclusively long-only traditional investments. Thus, the inclusion of long/short diversifiers means an underweight to traditional beta — the so-called ‘funding problem’. This was a painful experience for many investors over the last decade as stocks performed unusually well.

The solution: portable alpha

Portable alpha is the concept of combining a high-quality, long/short alpha strategy with an equity overlay utilising equities futures, which provides the desired exposure to the equity market plus the alpha from the hedge fund strategy. Therefore, portable alpha avoids the problems associated with long-only active management and ‘funding’ standalone long/short diversifiers with traditional investments.

In contrast to long-only managers, unconstrained long/short managers have more tools at their disposal, allowing them to better express their investment views by going long on securities they like and shorting securities they dislike. Additionally, long/short managers have access to prudent leverage, allowing them to form highly diversified portfolios (i.e. higher risk-adjusted return) and monetise the diversification (i.e. higher total returns). Lastly, by virtue of being unconstrained, index concentration is irrelevant for the efficacy of long/short active management.

The theoretical arguments in favour of unconstrained long/short active management are supported by actual investor experience. Over the past decade, the median hedge fund in the HFRI Fund Weighted Composite Index delivered a 1.8% active return (i.e. alpha) net of fees, which represents a 5.1% total return less 3.3% due to equity exposure, looking at trailing 10-year annualised returns ending September 30, 2024. For those with manager selection skills, a top-quartile hedge fund in the same index earned a 4.4% net active return (8.3% total return less 3.9% due to equity exposure), which is substantially more than long-only equity managers.

In addition to delivering active returns, portable alpha solves the ‘funding problem’. In the old world without portable alpha, an allocation to an attractive long/short diversifying strategy required selling stocks and/or bonds, i.e. being underweight traditional beta. In the new world with portable alpha, attractive long/short diversifying strategies can be included in the portfolio without being underweight traditional beta since the funding beta is replaced one-for-one by the beta overlay, included in the overall portable alpha solution.

Not all portable alpha implementations are created equal

In today’s marketplace, there are two common ways to implement portable alpha solutions. The first way, denoted as ‘complex’, separates the beta overlay function from the alpha manager function. The investor hires a separate beta overlay manager or manages the beta overlay internally. In contrast, the second way, denoted as ‘turnkey’, integrates the beta overlay function with the alpha manager function, i.e. the alpha manager puts on and is responsible for the beta overlay.

While the complex approach provides the investor with additional flexibility, it comes with additional risks. By separating the beta overlay function from the alpha manager function, the investor bears additional operational risk, collateral/cash management risk, beta estimation risk, and performance reporting risk. These types of risks make the complex portable alpha implementation accessible only to the most sophisticated institutions.

All of these real-world risks are mitigated with the turnkey approach. The turnkey implementation ‘walks and talks’ like any other beta-one, benchmark-oriented mandate, making portable alpha accessible to any investor as a core equity solution.

Portable alpha fair fees

In addition to offering different risks, portable alpha implementations can also differ along the fee dimension. When it comes to the performance fee, there are two common structures. The first structure, denoted as ‘unfair’, pays a performance fee to the alpha manager whenever the alpha strategy makes money. The second structure, denoted as ‘fair’, pays a performance fee only when the overall portable alpha total return beats the stated benchmark — the investor’s ultimate objective. Under the ‘unfair’ structure, the alpha manager can be paid a performance fee even though the overall portable alpha strategy is underperforming the benchmark, which we believe is unfair to the investor.

By comparing the portable alpha total return to the stated benchmark, the ‘fair’ structure automatically holds the ‘turnkey’ portable alpha manager accountable for operational expenses, financing frictions, and a proper hurdle rate, which we believe is fair to the investor. It should be noted that it is impossible to implement a ‘fair’ performance fee structure with the ‘complex’ portable alpha approach.

The concept of portable alpha isn’t new — large sophisticated institutional investors in North America and Europe have been users of portable alpha for years. However, the implementation of portable alpha has evolved since its founding in the early 2000s. In the early days, many portable alpha implementations used a separate beta overlay manager, held too little cash for managing the equity futures position, assumed the hedge fund was 100% alpha, and/or used illiquid alpha sources.

Thankfully, implementation has improved markedly over the past two decades. Turnkey approaches with fair fees are now available, making portable alpha both a safe and accessible core equity solution for all investors – and, importantly, an appropriate response to the current market environment of low expected returns and elevated macro volatility.

Peter Hecht is a managing director and head of the North America portfolio solutions group at AQR Capital Management