A Simple Equity Index Portable Alpha Strategy: Gaining Alpha From Short Duration Credit Exposure

 |  Includes: SPY
by: Glyndon Park


Portable Alpha Strategy allows investors to generate alpha over a target index.

Investors use futures contract for the index return while investing funds in alpha positions.

A Portable Alpha Strategy Using Limited Duration CEFs generates a substantial expected alpha.

Portable Alpha is a strategy that investors gain exposure to a target index and systematically add exposure to actively managed assets or risks to generate excess return. Ideally the actively managed assets or risks are uncorrelated to the target index. Portable alpha strategies are used by hedge funds and asset managers frequently and the number of alpha positions can vary from time to time.

Below we recommend a portable alpha strategy that is indexed to the S&P500. Our view is that short duration closed end funds offer an alpha generation opportunity where these funds will outperform the LIBOR funding costs.

With interest rates on the rise investors short maturity investments will outperform longer dated maturities. Limited Duration CEFs, such as those listed in the last table below, can provide additional upside. This is due to CEFs use of leverage to enhance yields and they can purchased at a discount to their net asset value.

In the portable alpha strategy the investor purchases S&P500 E-mini futures contracts to obtain the index return and invests some proceeds in a money market fund with the rest in CEFs described above. If the money market fund and CEF total returns exceeds the implied LIBOR cost of carry in the futures contract, the investor will generate a positive alpha return over the S&P500 Index

Let's use an example. We will begin with an investment equal to 100 times the S&P500 value, or $185,700. An investor could easily purchase am S&P500 ETF (NYSEARCA:SPY) and receive the index return. Let's assume the S&P returns 10% plus 1.8% in dividends.

Alternatively an investor could purchase two E-Mini S&P500 contracts to replicate the index return. The contracts trade at a slight discount to the index due to the forgone dividends offset by the cost of borrowing funds. Essentially over the course of the year the futures contracts will equal the total index return (including dividends) less the cost to borrow money to purchase what would have been the cash securities in index, typically LIBOR. Therefore the investor should expect to gain the same dividend income as the index investor less the borrowing cost. ($3,342 and $462.50 below)

Since the investor will be left with his cash of $185,700 some of it will need to be set aside to meet margin calls. We assume a level of 20%, will need to be set aside in a money market fund earning a paltry .08%. The remaining amount will be invested in a Limited Duration CEF, we've used Eaton Vance Limited Duration in this example with a yield of 7.95%.

Looking at the returns below the index fund returned 11.8%. Contrast that with the portable alpha strategy returning 17.93% a difference or alpha of 6.13%

It should be mentioned that the portable alpha strategy is not without additional risk. First, The active management could underperform the or even be negative and detract from the index. return. Second excessive volatility could cause some of the alpha to be sold to meet margin calls. We've allowed for 20% downside but if that were to go further the CEFs may be sold and unable to generate as much return with the reduced investment size.

Overall for a more sophisticated investor portable alpha offers an opportunity for enhanced returns. While we've assume a single alpha generating investment in this example one could easily diversify the active management across different strategies.

  Index Portable Alpha
Purchase SPY $185,700.00  
Purchase 2 ESH4 @1850   $185,000.00
Money Market 0 $37,000.00
Limited Duration Closed End Funds: Ev Limite Duration (9,681)   $148,700.00
Investment Returns (Annualized Assuming 10%)    
Index Return (10%) $18,570.00 $18,570.00
Dividend Yield (1.8%) $3,342.60  
Futures Implied Dividends   $3,342.60
Cost of Carry   $(462.50)
Money Market Return   $29.60
Closed End Funds (7.95%)   $11,821.65
Total Return $21,912.60 $33,301.35
Alpha   $11,388.75
% Return 11.80% 17.93%
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Ticker (ERC) (BLW) (EVG) (FTF) (EVV)
Fund Name Wells Fargo Adv Multi-Sec Inc BlackRock Limited Duration Inc EV Short Duration Diversified Franklin Templeton Ltd Dur In EV Limited Duration Income
Closing Price $14.45 $17.00 $15.08 $13.00 $15.36
NAV $16.30 $18.14 $16.72 $14.35 $16.58
Premium/Discount -11.35% -6.28% -9.81% -9.41% -7.36%
Distribution Amount $0.10 $0.10 $0.09 $0.07 $0.10
Distribution Frequency Monthly Monthly Monthly Monthly Monthly
Distribution Rate 8.30% 7.02% 7.16% 6.74% 7.95%
Earnings Per Share $0.10 $0.11 $0.07 $0.06 $0.10
UNII Per Share ($0.09) $0.10 ($0.02) ($0.08) ($0.12)
Effective Leverage 25.02% 29.67% 22.94% 19.26% 35.48%
Market Cap $608M $629M $284M $349M $1,806M
Baseline Expense Ratio 1.17% 0.92% 1.58% 1.12% 1.16%
Average Duration 4.95 yrs 1.52 3.06 yrs 4.00 yrs 3.26 yrs
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.