blog
Fasanara’s Alternative Credit Hedge Fund Strategies – A Compelling Alpha Source in a Portable Alpha Strategy
Ron Barin, Head of Global Strategy
7 August 2023
Portable alpha strategies have seen renewed interest by institutional investors due to the low expected return environment. Many lessons were learned from the underperformance of portable alpha strategies during the 2008 Global Financial Crisis and more robust collateral and downside risk management practices are being used by investors. The move to a higher interest rate environment adds new challenges for portable alpha programs to find alpha sources that can generate stable, persistent returns, with low correlation to public markets above the current higher cost of financing. Fasanara’s alternative credit strategies are an ideal source of alpha in a diversified hedge fund alpha manager line-up, as our strategies have generated stable, persistent returns with no correlation to public markets, and our returns have consistently exceeded the prior and now current, higher cost of financing.
Portable Alpha Overview
Portable alpha strategies, which have been used by institutional investors for decades, can help investors add meaningful additional expected returns while significantly decreasing total portfolio volatility.
Portable alpha is based on well-established investment principles:
o The best, most efficient way to construct a portfolio is to make independent asset class and external investment manager decisions as traditional actively managed equity and fixed income strategies combine the beta and alpha together and don’t generate much, if any alpha
o Therefore, separating market-based and skill-based returns will allow for a more effective deployment of an investor’s active risk management budget. The separation allows investors to exploit the best alpha opportunities which are typically found in the least efficient markets
o Institutional investors who obtain traditional market-based beta via passive index funds or who have underperforming actively managed equity and fixed income funds will likely realize the greatest benefit from a portable alpha strategy. It is very difficult to find persistent, alpha generating active public equity and fixed income managers
o The portable alpha beta exposure is obtained via derivatives which create portfolio leverage, and therefore, the alpha portfolio needs to be thoughtfully constructed to find hedge fund managers that can generate persistent, uncorrelated alpha with low downside risk to mitigate the sizeable collateral and margin call risk
o Portable alpha can typically improve expected returns by 2.0% (or more) on the portable alpha program allocation – the expected excess return is a function of the size of the portable alpha $ allocation relative to the cash reserve, the return of the alpha portfolio, less the cash cost of financing the derivative beta portfolio
Portable Alpha Implementation
Portable alpha allows for the separation of alpha and beta – the alpha is typically sourced from absolute return hedge funds and the beta from highly liquid equity or fixed income index derivatives. Absolute return hedge funds are typically used for the alpha source due to their low correlations with major market indexes.
The key considerations in implementing a portable alpha program include:
Beta Construction: Determine the most efficient derivative instrument to obtain the beta exposure – futures, options, or swaps. As the beta exposure is generated using derivatives, only a small amount of portfolio assets are required as upfront margin to create the beta exposure
Cash Buffer: Determine the proper size of the collateral buffer, which will help to protect against significant market drawdowns: most portable alpha programs maintain a collateral buffer of 30%-50%. This cash buffer should be sized conservatively to help avoid the forced raising of cash during a significant market downturn which could hurt long-term return performance
Financing Cost: The cost of credit to execute the derivative will be driven by the prevailing risk-free rate (SOFR), the funding basis (which reflects the cost to occupy space on a bank’s balance sheet and cost of capital regulation) and roll forward costs (if using futures). Of note, the funding basis has exhibited significant volatility over time and typically spikes during periods of financial turmoil
Alpha Portfolio Construction: The alpha portfolio is typically constructed using market-neutral and multi-strategy hedge funds as these hedge fund sectors have exhibited low historic correlations with major market indices. Of note, it’s challenging to find market-neutral and multi-strategy hedge fund strategies that can consistently achieve low correlation and generate a strong, positive return stream
o Market-neutral and multi-strategy hedge fund strategies are not always beta neutral and may contain embedded beta or be repackaging beta as alpha
o This embedded beta creates additional implementation challenges as the embedded beta needs to be estimated, monitored and the beta portfolio needs to be continually adjusted to incorporate this time varying embedded beta
o One of the worst case portable alpha risk program risks is that the alpha-seeking hedge fund manager fails to generate a return greater than the cash financing cost or produces negative returns (as seen in the 2008 global financial crisis)
The Portfolio Alpha Landscape Will Likely Be Altered by The Higher Interest Rate Environment
The move from a zero-rate to a significantly higher interest rate regime on the back the 2021 inflation spike has caused the risk-free rate (SOFR) to jump from 0.5% to 5.25%, as the Federal Reserve has hiked their policy rate at the fastest pace in the past 40 years. This new interest rate regime creates some benefits and challenges to portable alpha programs.
Benefits:
o A higher risk-free rate is typically a tailwind for hedge funds expected returns as higher rates have historically helped hedge funds generate higher returns
o This historic tailwind is due to a number of factors: Higher interest rate environments have been periods of higher market volatility and dispersion which may help to expand the alpha opportunity set, unencumbered cash earns a higher return, and short positions realize higher rebates
Challenges:
o The cost of financing the beta overlay derivative position has spiked from 0.5% to 5.25%, which may reduce the expected excess return generated by portable alpha programs
o Given that the portable alpha strategy return is a function of the hedge fund alpha return less the cost of financing, the large rise in the alpha hurdle rate may prove to be challenging for many market-neutral | multi strategy managers to exceed
o The charts below are an illustration of the expected portfolio alpha program benefit as compared to an active long-only US equity allocation under the prior zero-rate interest environment and the current higher interest rate environment. Our modeling shows that the expected portable alpha benefit is projected to decline from 2.2% to 1.3% (modeling assumes a 40% cash buffer). This is driven by the negative impact of the higher cost of derivative financing which is partially offset by the higher expected hedge fund returns (expected to increase from 4.5% to 7.8%) - see below:
Source: BlackRock
Fasanara’s Alternative Credit Strategies Are a Compelling Addition to An Alpha Hedge Fund Manager Line-Up
Constructing a hedge fund manager alpha line-up that can generate persistent, uncorrelated alpha returns above the derivative financing rate is one of the key challenges in building a successful portable alpha program. Therefore, portable alpha programs will strive to construct a multi-manger, diversified alpha portfolio that is adaptive. The program needs to recognize that there is high return dispersion between the best and worst-performing hedge fund managers and that relative performance across managers demonstrates a high level of change over time.
Fasanara’s alternative credit strategies possess the ideal characteristics for an alpha generating hedge fund manager portfolio:
Consistent Return Generation Fasanara has a long, successful track record of steady, consistent performance in excess of cash financing costs that has proven to be resilient to market volatility with significantly less volatility than other risk assets. Over the past nine years, our strategies have exhibited low downside risk as we have never recorded a negative month of performance
Uncorrelated Returns Fasanara’s credit strategies are uncorrelated to market beta and have no embedded beta. Our conservative, defensive investment process increases the likelihood that our strategies will continue to outperform the cash financing rate over future market cycles
High-Breadth Global Portfolio Fasanara's credit strategies make investments in millions of individual loans on a global basis. The extreme granularity of the portfolios ensures that no concentrated loans or factor bets are taken. The global nature of our loan portfolio provides us with the best opportunity set for maximum alpha generation
Short Duration, Self-Liquidating Loans Fasanara employs sophisticated algorithms to cherry-pick loans for its portfolios. Our credit strategies focus on short-duration loans, which self-liquidate over time, thus reducing the overall risk of our portfolio. This profile would add good diversification to a hedge fund's portable alpha strategy manager line-up, which often focuses on short-term, market-neutral investments. Further, the self-liquidating nature of our short-duration loans provides enhanced liquidity
Strong Historical Performance Fasanara's alternative credit strategies have a proven track record, with consistent, uncorrelated performance over the last nine years. This strong historical performance not only illustrates the strategy's resilience in a variety of market conditions but also significantly increases the likelihood of our ability to deliver similar results in the future
Fasanara, as a leader in non-bank Fintech lending, has successfully navigated through different market cycles since its inception 12 years ago. Fasanara’s credit strategies have been structured to be resilient and have a compelling record of generating stable, persistent returns with no correlation to public markets. Our strategies would add much-needed diversification to a portable alpha manager line-up, given our high-breadth portfolio construction and the global opportunity set of our loan sourcing. Our strategies have generated returns in excess of the historic cost of financing and we expect to be able to continue that track record in the current higher interest rate environment as Fasanara has been able to leverage its position as a market leader in the Fintech lending space in this higher interest rate environment by repricing loan transactions at an additional premium to enhance returns.