Portable Alpha Strategies: Legal and Structural Considerations
Understanding portable alpha
Portable alpha strategies allow investors to simultaneously capture both alpha and beta returns within a single investment vehicle. Alpha represents excess returns generated through active management, while beta represents market returns. The term "portable alpha" is somewhat of a misnomer in investment management. Rather than truly "porting" alpha, these strategies will import beta returns (eg, MSCI World returns) using swaps or futures from one investment source and combine those returns with alpha exposure from the manager's fund or funds.
Despite the nomenclature, portable alpha is increasingly relevant in today's investment landscape, with clients frequently inquiring about implementation and structure. These strategies are designed to allow investors to enhance returns by capturing alpha independently while maintaining traditional market exposure through beta returns.
Structural options and risk considerations
Structuring portable alpha strategies involves balancing efficiency against fiduciary and legal risks. The primary concern is "contagion risk", or the possibility that adverse movements in beta exposure might spill over and impact the alpha component.
Three principal structural approaches exist, each with distinct advantages and limitations:
- Managed accounts and funds of one – These present few legal or fiduciary issues and are easy to set up but present two negative issues: (i) the cost and complexity of replicating alpha trades at the managed account or fund of one and (ii) the only capital used to support the beta exposure is the single investor's capital.
- Class structure – Most cost-efficient of the three structures as everything resides in the same fund structure, but simply creating a new class presents the most contagion risk of the structures due to the proximity of the alpha and beta components.
- Separate feeder funds – Can provide a balance between legal risks and capital efficiency, especially if some amount of cash is held back at the feeder fund (or intermediate fund) level. While cross-class risk can still raise concerns with a separate feeder fund model, the cash provides a cushion should the beta component need additional capital during market turmoil.
Mitigating fiduciary risks
Fund managers employ various approaches to address fiduciary concerns, including:
- Limiting the size of portable alpha classes or feeders to control exposure
- Implementing fee arrangements where portable alpha investors compensate other investors for structural benefits
- Establishing clear margin call procedures
- Documenting risk disclosures comprehensively
It is important to note that these measures only mitigate, but cannot eliminate, the inherent risks of these portable alpha strategies.
Fee structures and documentation considerations
Fee arrangements for portable alpha structures remain non-standardised, reflecting the evolving nature of these strategies. Common approaches include:
- Applying traditional hedge fund fees solely to the alpha component
- Charging fees on net returns across the entire structure
- Using a hybrid approach with incentive fees on alpha and management fees on both components
Implementation of the portable alpha structure as a whole requires ensuring offering documents accurately reflect the fee calculation methodology.
As portable alpha strategies continue gaining traction, practitioners should recognize that market standards remain fluid, with structures often reflecting specific business negotiations between managers and investors.
The evolution of separately managed accounts
Understanding SMAs
A separately managed account (SMA) is a portfolio of securities managed on behalf of a single investor pursuant to an investment management agreement. Unlike pooled investment vehicles, in which multiple investors participate in a collective portfolio through a comingled fund structure, an SMA investor has direct ownership and custody of the underlying securities in the account. SMAs have undergone a profound transformation and evolved into an essential component of the fundraising and investment management landscape.
Investment managers of varying sizes, vintages, and investment strategies now routinely manage significant amounts of capital in SMAs. This represents a marked shift over the past decade, prior to which SMAs often were viewed as secondary to commingled fund structures and funds-of-one. While capital providers such as seed and anchor investors previously invested primarily commingled fund structures (with side letters), they now frequently deploy capital through SMAs.
The use cases for SMAs also have expanded dramatically. SMAs have become extraordinarily common in securing initial capital for emerging managers, and multi-strategy managers often use these structures to deploy significant capital to external managers. Moreover, while SMA structure often are best suited for liquid strategies (such as investments in publicly-traded securities), SMAs are being considered for, and utilised in, co-investment structures and less liquid strategies—areas where they were virtually absent a decade ago.
Legal and commercial considerations
One reason for the evolution and broad-based adoption of SMAs has been the market shift to alignment of liquidity terms (termination rights and ability to decrease notional trading value) with those of parallel commingled funds and other SMAs. Historically, SMA clients often demanded preferential liquidity compared to parallel commingled funds, creating fiduciary complexities and operational challenges for the manager. Now, managers often can secure SMA client agreement to liquidity terms that match (or nearly match) those of their parallel commingled funds and SMAs, reducing the risk of misalignment and ensuring fair treatment across investor types.
The contractual terms of SMAs also have become more sophisticated. For example, the parties now devote significant attention to leverage and financing mechanics. Key questions include how the cost of financing is allocated and how those costs are factored into management and performance fees. Expense allocation is another area of focus. Historically, SMA investors often paid fewer expenses (for example, research or alternative data costs) than their commingled fund counterparts, leaving managers to absorb the shortfall. Now, however, there often is far greater alignment, with SMAs typically bearing their proportional share of these expenses.
The SMA has evolved into a flexible, institutionally accepted investment structure that is increasingly attractive to asset managers and investors alike. Whether as part of launch capital, a platform deployment tool, or a bespoke co-investment arrangement, SMAs now are a key focus of manager-investor relationships, reshaping the commercial and legal terrain of asset management. As the market continues to innovate, we believe that SMAs are poised to remain at the forefront of investment structuring, offering tailored solutions in an increasingly complex investment landscape.
Originally Published by Chambers And Partners
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
