This problem exists because most plan sponsors feel compelled to seek alpha, or value-added, only within the asset classes stipulated in the policy asset mix. But, since a large percentage of the policy portfolio is allocated to efficient asset classes— like fixed income and large-cap U.S. equities—the alpha generating opportunities are limited. On the other hand, less efficient asset classes and strategies, like small-cap U.S. equities, tend to produce better risk-adjusted alpha. But they often represent a small portion of the overall asset mix, or are not included at all.
Portable alpha allows plan sponsors to obtain their policy exposures easily and inexpensively through index funds, derivatives and exchange traded funds, while sourcing the alpha where it is available.
BC: Is the portable alpha market fully developed for plan sponsors in Canada?
DB: Portable alpha is relatively new but is gaining traction in Canada. It’s something that sponsors want to learn more about. Many of the early adopters of portable alpha where large, sophisticated plans. But, with the advent of pooled and other fund solutions, these strategies are more accessible to plans of all sizes.
BC: Why would a plan sponsor go that route?
DB: To create a more efficient, better risk-adjusted portfolio. The traditional portfolio construction process is mired with a number of constraints that result in the creation of sub-optimal portfolios. By separating the policy decision from the active risk budgeting decision, plan sponsors will increase the number of managers and strategies they can choose from. This will provide them with more portfolio flexibility.
BC: How much risk should plan sponsors allocate?
DB: Recall, portable alpha is an alternative approach to allocating your active risk budget. That being said, the process for evaluating how much risk to take in portable alpha strategies shouldn’t be materially different from how plan sponsors currently determine their active risk budgets. Therefore, the amount of risk allocated to portable alpha will really depend on how much risk a plan sponsor is willing to accept to obtain a specified amount of alpha in the portfolio.
BC: Will finding a portable alpha manager be difficult?
DB: There are two aspects to finding a manager to create a portable alpha solution. The first is to find a manager that can consistently deliver a desired amount of alpha at a risk level that is acceptable. The second is to have a manager that can efficiently implement the policy asset mix and manage the integration between the alpha and the policy investments.
There’s no question that finding good active managers has its challenges. However, portable alpha increases the choices available to plan sponsors.
In addition, since the alpha and the policy investments are separated in a portable alpha strategy, plan sponsors should look for managers that can efficiently and effectively integrate the two components.
Joel Kranc is news editor of BENEFITS CANADA. Joel.email@example.com.