From the October 2005 issue of Investment Advisor • Subscribe!

October 1, 2005

Portable Alpha Investing

Institutions seeking better risk-adjusted returns are increasingly employing a portable alpha approach, in some cases using this method to invest with multistrategy hedge fund managers through funds of funds.

A reason for this approach is that a portable investment has the benefit of not altering the institution's overall asset allocation--it separates the manager choice from the asset type.

This is done by either hedging out the beta return or, in the case of hedge fund investments, constructing the portfolio with the objective of getting pure alpha with no exposure to underlying asset classes. If desired, beta is obtained from a swap or other instrument linked to the performance of an index.

"Our clients now have sizable portable alpha hedge fund investments," said Roger Fenningdorf, a founder and partner of Rocaton Investment Advisors, Norwalk, Connecticut. Institutional investors are increasingly putting in more such programs, he says.

Rocaton's clients are pensions, both public and private, and insurance companies, as well as financial intermediaries. The consulting firm has advised on approximately $225 billion in assets, of which more than $10 billion was placed in hedge funds, since it was founded in April 2002.

Mr. Fenningdorf remembers the first portable alpha investment he worked on. That was in 1998; at the time he and his colleagues were at Barra RogersCasey and had not yet started Rocaton. The approach was novel and based on a traditional long-only portfolio.

Since then portable alpha investments have become more widely accepted and increasingly based on hedge funds. It's a major trend now, says Mr. Fenningdorf. Pensions in particular are taking this route.

Portable alpha can be applied to active long-only investments or absolute return investments. In the latter case, it is typically used with a fund of funds rather than a single hedge fund.

But multistrategy managers are also becoming more common in portable alpha portfolios. A multistrategy manager has the potential to quickly reallocate between asset classes and strategies as market conditions change--an advantage that is attracting investors.

While they are still usually anchored with a fund of funds, portable alpha portfolios may include direct hedge fund investments as well. There are even some that consist of direct investments alone. "We work with each client to develop the right structure for that client," Mr. Fenningdorf said.

For the purpose of portable alpha, Rocaton targets a return of 300 to 400 basis points in excess of cash. Mr. Fenningdorf points out that last year's hedge fund returns satisfied this criterion, despite being lackluster in comparison to past double-digit performance. It depends on what you look for, he says.

In his experience, institutions are seeking added sources of alpha to enhance returns, given the current conditions in capital markets. Passive investments are not yielding enough, while active management does not add much risk-adjusted value in efficient markets like large-cap U.S. stocks unless the manager is very good.

That means a wide-reaching search is on for better returns, including through the use of portable alpha.--Jeff Joseph and Chidem Kurdas, New York Bureau Chief

Chidem Kurdas is the New York Bureau Chief at HedgeWorld; Jeff Joseph is managing director of Rydex Capital Partners and serves on the advisory board of HedgeWorld (www.hedgeworld.com), a global provider of hedge fund information and investment products.

Have a question about hedge funds? Feel free to contact Jeff Joseph at jjoseph@rydexfunds.com.

For inquiries about HedgeWorld's services, e-mail inquiry@hedgeworld.com.

Jeff Joseph is managing director of Rydex Capital Partners and serves on the advisory board of HedgeWorld (www.hedgeworld.com), a global provider of hedge fund information and investment products.

Have a hedge fund question? Contact Jeff Joseph at jjoseph@rydexfunds.com.

For inquiries about HedgeWorld's services, e-mail inquiry@hedgeworld.com.

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