You Can't Eat Risk-Adjusted Returns | AQR's Pete Hecht on Portable Alpha's Capital Efficient Edge

Key Concepts

• Portable Alpha: Delivering the benefits of unconstrained active management (alpha) within a benchmark-oriented framework (beta 1), solving the funding problem of traditional alternative investments.
• Fusion Funds: AQR’s turnkey portable alpha solution offering access to various alpha sources with a beta 1 S&P 500 overlay.
• Total Return Focus: Prioritizing total returns over risk-adjusted returns, as “you can’t eat a risk-adjusted return.”
• Capital Efficiency: Seeking strategies that improve both risk-adjusted and total returns, unlike some alternatives that only improve risk-adjusted returns.
• Tax Efficiency: Implementing strategies to maximize after-tax returns, challenging the notion that ETFs are always superior to mutual funds in this regard.
• Diversification: A core investment principle for mitigating risks related to market crashes, inflation, and other macro events.

Portable Alpha & Fusion Strategies: A Comprehensive Overview

Defining Portable Alpha & Addressing the Funding Problem

Portable alpha is a strategy designed to deliver the benefits of flexible, unconstrained active management – generating alpha through long/short investing across various asset classes – while maintaining a desired benchmark exposure (beta 1). This addresses a key challenge for investors: diversifying into alternative investments often requires selling core equity holdings, leading to potential regret if equities outperform. Portable alpha allows investors to maintain their equity allocation while adding alpha, effectively “porting” alpha onto a traditional market exposure like the S&P 500. AQR’s Fusion funds are presented as a turnkey solution for implementing this strategy.

Implementation & Leverage Considerations

Portable alpha can be implemented in two ways: a “turnkey” approach (preferred by AQR) where a single manager handles both alpha generation and beta overlay, or a more complex approach with separate management. The turnkey approach minimizes operational and cash management risks. Careful management of leverage is critical, differentiating between long leverage (amplifying risk) and long/short leverage (potentially risk-reducing). Targeting volatility and maintaining sufficient free cash are essential components of responsible leverage management. Financing friction for S&P 500 futures is cited as being in the range of 70-80 basis points annually.

Evaluating Portable Alpha Programs

Evaluating a portable alpha strategy requires a two-step process: first, verifying the strategy consistently delivers on its beta 1 mandate (e.g., tracking the S&P 500); and second, analyzing active returns (total returns minus the stated benchmark) to assess the quality of alpha, including volatility, performance in stress scenarios, and tail risk. The focus should be on the overall program’s return relative to the benchmark, not just the standalone alpha generated by the manager.

The Importance of Total Return & Capital Efficiency

A central argument is that investors need total returns to meet their obligations, not just risk-adjusted returns. Portable alpha aims to deliver both. A key distinction is made between uncorrelated alternative investments that improve risk-adjusted returns without improving total returns (deemed “capital inefficient”) and portable alpha solutions which aim to improve both.

Current Market Context & Investment Philosophy

Despite potentially elevated equity valuations and yield environments, equity beta remains a core component of strategic asset allocation. Portable alpha provides a way to honor this preference while adding long-short alpha not susceptible to valuation concerns, index concentration, or shifts in Federal Reserve policy. AQR’s investment philosophy prioritizes diversification as a means of mitigating risks related to equity market crashes, inflation shocks, and other macro events. Long-short alpha strategies provide idiosyncratic return sources less correlated with these broad market risks.

Tax Efficiency & Mutual Fund Relevance

AQR differentiates itself by prioritizing after-tax returns, implementing fusion funds in a tax-aware manner to maximize returns after taxes, a practice they are expanding across their liquid alts platform. This challenges the conventional wisdom that ETFs are always superior for tax efficiency. AQR’s experience demonstrates the feasibility of tax-efficient mutual fund management through active turnover and security selection.

Valuation & Signal Generation

Any investment “view” must be assessed relative to what is already priced into current valuations. A correct view is not necessarily profitable if it’s already reflected in market prices. AQR is leveraging machine learning tools (natural language processing) to identify new return-predictive signals and optimize portfolio construction, emphasizing the importance of a “recipe” (signal weighting and implementation) beyond just identifying ingredients (signals).

Conclusion

Portable alpha, particularly as implemented through AQR’s Fusion funds, offers a compelling approach to accessing alternative investment strategies. By delivering alpha within a benchmark-oriented framework, it addresses the funding problem of traditional diversification, prioritizes total returns, and emphasizes capital efficiency. AQR’s focus on tax efficiency and rigorous evaluation of program performance further strengthens the case for considering portable alpha as a core component of a well-diversified portfolio. The key takeaway is that successful implementation requires a holistic view, focusing on the overall program’s performance, careful leverage management, and a commitment to delivering after-tax returns.