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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 actively-managed funds is the generation of "alpha" return. Alpha is a measure of risk-adjusted 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 risk-adjusted 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 newly-hired Chief Investment Officer (CIO) for the billion-dollarplus defined-benefit 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 $150 million allocation that has been placed with an outside investment manager; this manager has fully-invested these funds in a very conservative bond portfolio that attempts, in aggregate, to passively match the returns from the Bloomberg Barclays U.S. Aggregate Bond Index.* You would like for this allocation to generate excess risk-adjusted 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
*(C)Bloomberg L.P.
1
fund can take a long position in $150 million of futures contracts on the Bond Index traded on the Chicago Mercantile Exchange (CME). Next, the $150 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 200-250 basis points (2.0-2.5%) per year on a risk-adjusted basis (its alpha). Finally, your pension fund should take a short position in $150 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 three-piece 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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