Research work recently carried out by the Edhec Risk and Asset Management Research Center has demonstrated that active portfolio managers, who attempt to generate abnormal profits through bets on well-identified risks, can benefit from using suitably packaged derivatives satellite portfolios as portable alpha and beta vehicles.
These portfolios, based on active asset or sector allocation decisions, can be used either as standalone absolute return alpha providers, or as overlay portfolios customised to help managers modify the exposure of their portfolios with respect to a variety of sources of risks on which they have no desire to bet.
In the paper entitled ‘Portable alpha and portable beta strategies in the Euro-zone – implementing active asset allocation decisions using equity index options and futures’, forthcoming in the Journal of Portfolio Management, the researchers show how to construct a pure overlay portfolio that is designed to capture excess return through tactical asset and factor allocation decisions on the European markets, using active management of betas to generate (portable) alphas.
They focus on pure active allocation decisions implemented through trading in index derivatives markets so as to study the performance of an overlay strategy that is not impacted by stock picking decisions.
In table 1, extracted from the paper to which the reader is referred for further details, they show, among other findings, the results obtained in the case of an absolute return strategy (benchmark: one-month LIBOR) implementing a tactical asset allocation (long or short bets on the DJ EURO STOXX 50 index using futures contracts) with a gross leverage fluctuating from 1 to 2 (net leverage from 0 to 1). The differences observed between the two experiments lie in the fees (monthly management fees: 0.075%, monthly administration fees: 0.045%) taken into account in the second back test.
The economic significance of the timing strategy can be seen from the overperformance of the portfolio. For example, in the above-mentioned absolute return strategy with a benchmark 100% invested in cash, the annual performance is a solid 8.28% (respectively 7.07% fees included) for a 5.55% (respectively 5.57% fees included) standard deviation. Such a performance can be easily compared with that of a typical market neutral hedge fund.
Another possible form of an active asset allocation strategy involves implementing an option-based portfolio strategy, of which the sole objective is to modify the asset allocation risk profile in the portfolio. In particular, options on equity indices can be used to truncate return distributions with the aim of eliminating the few worst outliers. In the paper referred to, the research teams show how suitably designed option strategies can be used to enhance the performance of a market timing strategy, the objective being to design a programme which would consistently add value during the periods of calm markets, which are typically not favourable to timing strategies. To demonstrate the benefits of such an approach, the researchers have implemented an option overlay strategy by selecting call and put options on the DJ EURO STOXX 50 index with strike prices symmetrically distributed around the at-the-money level. Call and put options to be sold have been chosen so that the strike price is the closest to current index price +50 (case of a call option) or current index price -50 (case of a put option). Longer-term (ie, expiring in month m+2) call and put options to be purchased have been chosen so that the strike price is the closest to the current index price +100 (case of a call option) or current index price -100 (case of a put option). The quantities in the top and bottom strangle strategies have been optimised so as to maximise the net theta of the overall position, while satisfying a euro-neutrality constraint.
Table 1 contains an overview of the results obtained through this experiment. The previous experiment (see ‘back test no 2’) corresponds to the results shown below in column ‘TAA without options’. Both experiments with and without options include management and administration fees over a 36 month period.
As can be seen from table 2, the tactical asset allocation performance can be further improved by using an option overlay portfolio as a portable beta vehicle. This option-based strategy would have added 121 basis points in terms of average returns, without increasing the level of risk (annualised volatility: 5.58% versus 5.57%, downside deviation (3%): 4.78% versus 4.46%, negative months: 13.89% versus 16.67%). The option overlay strategy therefore acts as a real return enhancer while mitigating the negative outliers (peak-to-valley: -3.18% versus -3.54% without options, worst monthly drawdown: -2.95% versus -3.04% without options).
Noël Amenc, Philippe Malaise and Lionel Martellini are professors in finance at EDHEC Graduate School of Business. Daphné Sfeir is a senior research engineer at EDHEC Risk and Asset Management Research Center. The author for correspondence is Philippe Malaise, email address: philippe.malaise@edhec.edu. We thank Elizabeth Regan and Brendan Bradley for very useful comments. This research has been sponsored by Eurex. The complete study is available at http://www.edhec-risk.com or www.eurexchange.com > investors > institutional investors > academic research

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