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In the investment management industry, the common goal for all managers of actively - managed funds is the generation of alpha return. Alpha is a
In the investment management industry, the common goal for all managers of activelymanaged funds is the generation of "alpha" return. Alpha is a measure of riskadjusted excess return performance when compared to the risk of the broader market uniformly known as beta. If you can identify managers who can outperform on a riskadjusted basis, derivative financial assets can be used to isolate and capture this source of investment excess returns. Strategies that accomplish this are called "portable" alpha.
Imagine that you are the newlyhired Chief Investment Officer CIO for the billiondollarplus definedbenefit pension plan for a major corporation. Your mandate is to ensure that the pension fund's investment portfolio the plan's assets will meet its future obligations to pay the retirement benefits the plan's liabilities that are owed to the corporation's retirees. One very small piece of this pension plan is a $ million allocation that has been placed with an outside investment manager; this manager has fullyinvested these funds in a very conservative bond portfolio that attempts, in aggregate, to passively match the returns from the Bloomberg Barclays US Aggregate Bond Index. You would like for this allocation to generate excess riskadjusted returns alpha but you realize that shifting capital from the bond index to active bond managers is not likely to produce consistent significant excess returns. However, you are confident that you can isolate and capture the alpha you believe that selective hedge funds can generate. The difficulty is that you have been told by your supervisor the CFO that the firm currently has no allocation to alternative assets including hedge funds but is willing to consider approving an allocation only if the proposal is reasonable.
Using your knowledge of derivative financial assets, which was acquired in your business school studies, you have carefully designed and are about to recommend the following portable alpha strategy to replace the current bond index allocation. First, your pension
CBloomberg LP
fund can take a long position in $ million of futures contracts on the Bond Index traded on the Chicago Mercantile Exchange CME Next, the $ million of assets that have been allocated to the bond index portfolio can instead be transitioned shifted to a hedge fund manager. For this piece of the strategy you have identified a hedge fund that invests exclusively in stocks in the technology sector, and consistently beats its benchmark tech stock index by basis points per year on a riskadjusted basis its alpha Finally, your pension fund should take a short position in $ million of futures contracts on the Technology Sector Index, also traded on the CME. The long and short futures positions will need to be rolled over each calendar quarter, but if executed properly this strategy should generate the excess returns that you are seeking to capture.
Explain this threepiece program by providing clear and concise answers to the following questions.
What two positions are effectively synthetically being taken with the long futures position on the Bond Index?
What two positions are effectively synthetically being taken with the short futures position on the Technology Sector Index?
Once the program is fully implemented, what net annual returns would you expect the pension plan to earn from this strategy? Your answer should be descriptive, not numerical.
Why is it necessary to take a short position in the Technology Sector Index futures contract? Hint: This short position serves two purposes.
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