Boosting Credit Investment Returns with Structural Alpha
The typical alternative credit fund investor intuitively understands the fundamental relationship of investing: that potential return is generally informed by the degree of risk accepted. In other words, the higher the expected risk, the greater the potential return an investor should demand.
Asset prices are impacted by certain common categories of risk – broad market volatility (sometimes referred to as beta), growth expectations, liquidity conditions and creditworthiness.
The Elusive Pursuit of Investment Alpha
Portfolio managers attempt to outperform the market (and generate alpha) by identifying favorable inefficiencies across the spectrum of the risk/return relationship and by investing in assets and strategies in which these inefficiencies can be monetized.
The supply of such opportunities, however, is generally quite constrained, and managers’ ability to find and capitalize upon such opportunities can be uneven. In fact, there is a popular view that the market is inherently efficient and assets are priced correctly at any given time.
Of course, this theory of efficient markets is far from universally accepted. The sheer volume of active managers, specialty and thematic investment strategies demonstrates the degree of support for diverging opinions.
Contrary to the idea that the market is always efficient, many investors subscribe to the notion that a combination of publicly available information, proprietary research and individual analytical skill and expertise may be applied to identify mispriced assets and to outperform the market. In this case, the ability to sustain market outperformance depends upon the frequency with which the investor can identify and capitalize on inefficiencies prior to other parties recognizing and closing the dislocation in the risk/return relationship.
Regardless of the view that resonates, however, it seems clear that exploiting such inefficiencies, to the extent that they exist, and generating alpha require some measure of investing expertise—a major barrier to entry for the non-professional.
The Value of Structural Alpha
Let’s now turn from investment theory to investment structure, and in particular to the concept of ”structural alpha”.
Capturing structural alpha means to consistently and reliably achieve a higher level of post-tax investment return for a given level of risk, relative to the market index or benchmark.
To capture structural alpha is not to achieve a higher level of return for a given level of risk based upon timing, special trading strategies, or security selection—as these methods require unique professional skill and are not likely to be sustainable by a casual participant in the market.
Instead, solutions that offer the prospect of structural alpha generate and preserve incremental post-tax wealth without seizing upon temporary market risk/return dynamics.
Benefits of Structural Alpha
Structural alpha can be generated within a variety of tax-favored investment vehicles, including certain private placement alternative investment strategies and through insurance structures. Alternative investment strategies that are designed to generate structural alpha are attractive because they are readily available, assuming the requirements associated with being an accredited investor and, in some cases, a qualified purchaser, can be met. Since structural alpha is based upon implementing established tax-favorable constructs available to select individuals and institutions rather than exploiting temporary market inefficiencies, the investments have the ability, at least in theory, to generate relatively sustained excess returns.
The ability to access structural alpha is constrained by certain process frictions, eligibility rules and transaction costs. Net worth requirements and other investing complexities (e.g., liquidity constraints, call provisions, run-off requirements, etc.) mean that an investor who is able to overcome these wealth and provisional thresholds is entering into a market that is not open to the mass public, which is a key assumption of the aforementioned efficient market hypothesis. Accessing structural alpha through insurance structures may have the additional benefit of providing policyholders the ability to contribute more assets into such structures relative to other tax-advantaged plans and are therefore extremely attractive to institutional investors.
Insurance solutions that optimize structural alpha include life insurance and annuities. These solutions offer tax-advantages such as deferring current income or passing assets to beneficiaries tax-free. Adept asset location management through insurance can have a significant impact on after-tax returns since it minimizes current tax liabilities and these savings compound as long as the policy is in-force.
Quantifying Structural Alpha
Two examples show how structural alpha can be quantified. With tax-advantaged structures, such as private placement life insurance (PPLI) and private placement variable annuities (PPVA), an investor would most likely receive a better after-tax return than with standard, taxable structures.
This excess return is especially evident when the policies are coupled with illiquid alternative credit strategies with high-turnover or current income as investment accounts within the policies. A superior outcome can be illustrated by comparing the annually compounded tax drag and the after-tax proceeds received, following withdrawal of the overall capital, between fully taxable and tax-advantaged, structural alpha oriented strategies.
Tax-advantaged structures can also provide measurable structural alpha by reducing the overhead and corresponding expenses resulting from complex administrative functions. By outsourcing tax-reporting, preparation and filing to an insurance provider, an investor can save substantial third-party professional service expenses or other related opportunity costs.
Still, the investor must also keep in mind that the amount of structural alpha generated is dependent on many variables, particularly with PPLI and PPVA insurance products. These variables can include the characteristics of the underlying investment, the sequence of returns, the weighting of short-term vs. long-term gains, the characteristics of one’s tax jurisdiction (both residence and company domicile), policy and investment management fees and expenses, and one’s current tax liability in any given year, among others.
A Pursuit Worthy of Consideration
To generate structural alpha, therefore, is to invest in credit using investment structures that are transparent, easy to acquire for informed and eligible investors, and do not require exceptional investment expertise. Clearly, structural alpha is not completely accessible to every investor and can expose the person to other types of risk (e.g., mortality, tax and regulatory, among others). It is, however, generally available to accredited investors and qualified purchasers with a medium to long investment time horizon, expert origination advice and access to qualified service providers.
When all of these things come together, the improvement in after-tax returns can be notable.
Written by: Chuck Nachman, CFA, U.S. President and Chief Operating Officer at Axcelus Financial
This document has been prepared solely for informational purposes only and is not to be construed as an offer or solicitation for the purchase or sale of any financial instrument. This information is not intended to constitute legal, tax or investment advice. Please consult with a qualified advisor for professional advice. Products not available in all jurisdictions.
