Sabrina C. Callin, CFA
Executive Vice President

Ms. Callin is an Executive Vice President and the head of the StocksPLUS product management team responsible for PIMCO’s global portable alpha-based equity business. She has 14 years of investment experience and holds two bachelor’s degrees with majors in finance, accounting and economics from Texas Christian University, and an MBA from the Stanford University Graduate School of Business. She is also a Certified Public Accountant.

Portable alpha is definitely a hot topic in the investment world these days. While portable alpha may be new to some investors, PIMCO has a long record of experience with these strategies dating back to the launch of our portable alpha-based StocksPLUS strategy almost 20 years ago. We asked Sabrina Callin, PIMCO’s StocksPLUS Product Manager and an expert on portable alpha, to describe why this topic is so important and what key considerations investors should think about when employing these strategies.

Q: Investor interest in portable alpha has been rising rapidly. What is portable alpha, exactly?
Callin: Let’s start with the concept of alpha. Alpha is defined as risk-adjusted return relative to a desired market exposure. In theory, portable alpha strategies allow investors to obtain alpha from a wide variety of different cash investment strategies that are entirely distinct from the investor’s desired market exposure, the latter of which is typically known as beta. Because the alpha source is independent, alpha can theoretically be transported to any desired beta.

In the financial press and at conferences, you’ll come across of variety of descriptions of how the theory of portable alpha is put into practice, and the variation is even greater when it comes to the bases that various money managers use when reporting their assets under management in “portable alpha strategies”. But the vast majority of portable alpha-based strategies feature three basic components: the desired market exposure or beta, the cost of obtaining the desired market exposure, and the cash investment, or alpha, strategy.

Q: Can you give an example of how a manager might use these basic components to create a portable alpha strategy?
Callin: In the vast majority of portable alpha strategies, the investor’s desired market exposure is obtained through derivatives, which allows the manager to capture the desired market return while still retaining the bulk of the portfolio’s cash for investment in an alpha strategy. As with any other arrangement where someone obtains an asset—a house, or a car, for instance—without paying for the whole value of that asset up front, there is an interest rate cost associated with financing the desired market exposure via derivatives. This interest rate cost—usually tied to LIBOR or a similar short-term rate—becomes a benchmark for the alpha strategy. If the alpha strategy outperforms its benchmark, those excess returns are effectively transported onto the market return provided by the derivative exposure. As you can see, the alpha strategy can be completely independent of the desired market exposure.

Q: Why are investors so interested in portable alpha these days?
Callin: Two factors seem to be driving the interest in portable alpha. First, many investors expect returns from traditional asset classes and investment strategies to fall short of their return targets. Second, many pension plans and other investors have liabilities that are sensitive to changes in interest rates, and these investors are searching for ways to improve the match between their assets and liabilities without giving up too much in terms of the overall expected return. In theory, portable alpha strategies can provide potential solutions for both challenges and improve an investor’s overall investment risk/return profile, without requiring dramatic alterations to traditional asset allocation models.

And with the growth in new derivative instruments that can provide beta exposure, investors are being offered an increasingly broad set of portable alpha strategies that hold the potential to be pretty powerful investment applications. In many cases, portable alpha strategies may offer excess returns that are generally both more reliable and more attractive than excess returns delivered by traditional active management strategies in a given asset class.

Q: PIMCO has been managing portable alpha strategies for nearly 20 years. Based on that experience, what factors should investors consider when taking portable alpha from theory to practice?
Callin: Risk controls and liquidity are critical factors to consider when implementing a portable alpha strategy. One of the reasons that risk controls are essential is because using derivatives to gain market exposure can lead to unintentional leverage.

The cash invested in the alpha strategy is the source of potential alpha, but that cash also serves as collateral on the derivatives position. Therefore, capital preservation is very important and it necessarily follows that understanding and measuring the risks in the alpha strategy is essential.

Liquidity is critical because maintaining the desired market exposure by using derivatives will typically result in daily, or at least monthly, cash flows. If these cash flows and associated unrealized payables and receivables are not managed effectively, the overall portfolio’s alpha could be reduced at best and, at worst, the beta exposure may be unintentionally removed at the wrong time.

Q: Let’s go through the practical considerations involved in each component of portable alpha. What are the key considerations when it comes to obtaining the desired market exposure?
Callin: The first consideration in obtaining the desired market exposure in a portable alpha strategy is how the strategy obtains the market exposure. As we discussed earlier, the market exposure is typically obtained on a forward-settled basis using derivative instruments because derivatives allow an investor to obtain the desired market exposure while deferring to the future or avoiding altogether the settlement of most or all of the total nominal exposure.

Futures, if they are available and liquid, are typically the lowest cost way to obtain the desired market exposure synthetically. Futures typically require the investor to post a small initial margin deposit, usually 2% to 8% of the total futures exposure. In addition, the investor must post daily variation margin as the market value of the futures contract fluctuates, so one consideration with futures is the need to carefully manage the daily cash flows. These cash flows involve both cash inflows and outflows that need to be efficiently reinvested to maximize return potential. Another consideration with futures is that contract expirations will require the investor to roll the market exposure forward into a new contract on a quarterly basis. Futures are also regulated—the Commodity Futures Trading Commission regulates U.S. futures, for example—so regulatory issues need to be considered as well.

Q: What if a liquid futures contract isn’t available for obtaining the desired market exposure?
Callin: Increasing liquidity in the swap markets provides an important alternative method of obtaining the desired market exposure, which may be particularly important when a futures contract is not available. A swap contract is an over-the-counter agreement and typically involves monthly cash flows to or from a counterparty, creating important legal and contractual issues to consider. Counterparty risk must be managed carefully, which can require extensive legal expertise and resources. Swap contracts also tend to expire after a year, requiring that the market exposure be rolled annually.

In addition to swaps, various other types of forward exposure instruments, including new types of structured products and vehicles may be used to obtain the desired market exposure in some portable alpha-based applications. If no liquid vehicle is available for obtaining the desired market exposure and it becomes necessary to use some type of proxy for the desired market exposure, investors should keep in mind that there may be a considerable (and undesirable) variance between the alpha strategy manager’s original return over LIBOR and the actual, realized excess return relative to the desired market exposure in a portable alpha strategy.

Q: What should investors consider when it comes to the cost of obtaining the desired market exposure?
Callin: As I described earlier, there is a financing cost associated with gaining the desired market exposure through derivatives. The financing cost is a critical consideration because this is the benchmark that the alpha strategy must outperform in order to produce excess returns that can be transported onto the desired market exposure.

The financing cost is typically tied to a money market interest rate, most often LIBOR. However, depending on a variety of factors, the financing cost can vary to a considerable degree across different asset classes, market indexes and other market exposures. For example, liquid futures contracts are not available for every market exposure an investor might want. If the desired market exposure is obtained through an illiquid futures contract or swap contracts, the cost of that exposure may be higher or more variable than would be the case with a liquid futures contract. The financing cost can also change over time as futures are rolled or swap contracts renegotiated. Minimizing the financing cost for both liquid and illiquid derivatives contracts is important and requires skill on the part of the manager.

Q: This brings us to the third component of portable alpha, the alpha strategy. What practical considerations should investors have in mind when it comes to the alpha strategy?
Callin: A portable alpha strategy should be successful if, over the investor’s horizon, the alpha or cash investment strategy can outperform its benchmark. For a derivative-based beta exposure, the benchmark is the embedded financing cost I explained a moment ago. However, there are a few significant additional considerations that relate to many of the factors we’ve already discussed.

The alpha strategy should be reasonably liquid, especially if the desired market exposure is relatively volatile. Market exposure to a volatile asset class can require material cash flows over relatively short time periods. Also, since the alpha strategy serves as collateral for the derivatives exposure, it should be reasonably reliable for purposes of long-term capital preservation. This means there should be a high level of transparency in how the alpha strategy is managed. Untested or higher potential risk strategies should be very carefully evaluated and stress tested.

Investors may also want to weigh the potential benefits of various alpha strategies. For example, if the alpha strategy and the desired market exposure have a low expected correlation, there may be an important diversification benefit that accrues to the aggregate strategy. As another example, investors with liabilities that are sensitive to changes in interest rates may benefit from an alpha strategy that is positively correlated with bonds.

Q: Could an investor use two different managers to implement a portable alpha strategy, using one as the source of alpha and the other to manage the beta?
Callin: It is possible to use two different managers, but there are additional potential costs and important considerations that warrant careful consideration when separating the “alpha” and “beta” management in a portable alpha strategy.

An investor attempting to use two managers to implement a portable alpha strategy will need to have processes and procedures in place to direct cash flows between the two managers as needed, with minimal notice. Tight, ongoing communication between the managers, as well as risk controls, will be necessary to make sure that the cash flow requirements associated with the derivatives are met. The manager hired to maintain the desired market exposure using derivatives must have the infrastructure to support this type of communication, with minimal risk of miscommunication and human error. In fact, the investor may need to maintain cash on hand, or with the beta manager, to meet margin calls or swap flows in the event of a decline in the associated market. The lower, cash-like return on this cash collateral will likely reduce the overall return of the portable alpha strategy.

And from a reporting perspective, the investor, or a provider, will need to devote additional time to calculating the return of the overall strategy relative to the appropriate market benchmark and prepare consolidated reports that provide aggregate risk, liquidity and other relevant statistics.

In addition, all of the other factors previously discussed will be important and may require extra work and very close coordination if the alpha strategy is managed separately from the desired market exposure. For example, the daily value of the alpha strategy relative to the beta exposure must be monitored to prevent undesired leverage. It will also be important to closely monitor the overall risk characteristics of the collective portable alpha strategy and make adjustments to the exposures in the alpha strategy as necessary for realized and unrealized cash flows associated with the beta exposure.

Q: Sabrina, we’ve discussed a lot of factors to keep in mind. Would you mind summing all of this up for us?
Callin: The concept behind portable alpha is relatively straightforward. First, obtain the desired market exposure using derivatives and, second, attempt to enhance the market return by investing the cash retained in a strategy that, all in, should deliver returns that are greater than the associated LIBOR-based financing cost of the desired market exposure. While relatively straightforward in theory, a portable alpha manager must have significant knowledge regarding all components of a portable alpha strategy and should understand the intricacies involved with implementation.

Assuming all of the appropriate criteria are met, the benefits of a portable alpha strategy can be compelling. When all of the potential desired market exposures and enhancement strategies that may be employed to achieve different objectives are considered, the possibilities really are seemingly, endless. Choices are still growing with the introduction of new derivatives contracts and new potential alpha strategies. The end result: a potential for reliable excess return that may help investors meet or even exceed return targets and achieve other objectives that may not have otherwise been possible.