Alpha Edge Recognition - Next Gen in Alpha Generation
This year, Allocator Intel is recognizing industry leaders for their insight into portfolio construction through the Alpha Edge Recognition Awards. Nominated as a Rising Star for Alpha Generation, Justin Young joined Multilateral Endowment Management Company (MEMCO) in April of 2023 from the South Carolina Retirement System Investment Commission. He spent 11 years at the $40 billion public pension fund, where he rose from Investment Analyst to Director, and managed the fund's $5 billion portable alpha hedge fund portfolio, which generated over $1.4 billion in excess returns since the program was implemented in 2016.
At MEMCO, the $2.5 billion not-for-profit investment manager, Justin will be a generalist investor across public and private markets but will have a special focus on uncorrelated strategies to help meet client needs in a wide range of market scenarios.
The following is edited for length and clarity.
Tell us a little bit about your role and what it looks like today versus your last entity.
At South Carolina, I managed the hedge fund program. We had a very tight mandate which was for essentially zero beta, low volatility, and very consistent returns with minimal drawdowns. The book had a core allocation to cross-asset relative value strategies and used macro, CTA, and reinsurance to mitigate liquidity driven drawdowns in the RV book. I also spent a lot of time and really enjoyed building out our investment associate program during my time at RSIC. We recruited a talented group of curious and hardworking students in recent years. They are a large part of the investment team today and continue to do great work.
At MEMCO, we’re all generalists, but over a third of total client assets are in hedge funds which means I have plenty to do. However, it’s also worth highlighting that at MEMCO there is not a single portfolio. Each of MEMCO’s clients has a different set of guidelines, goals, and asset allocation reflecting their unique spending, liquidity, and return targets as well as tolerances around drawdowns. We have endowment, foundation, and government clients. The majority of our assets are endowed funds, but we also have LDI and short duration portfolios which creates a very stimulating work environment.
A lot of our allocators are discussing portable alpha. What advice would you share?
At its core, portable alpha is a very simple concept. Just replicate beta using futures/swaps and instead of holding cash to collateralize those instruments, invest a part of that cash in hedge funds. If hedge funds outperform cash (plus some small financing spread) you’re better off. The excess returns can then be compared to traditional long only managers. It’s the most reliable way I have found to consistently and materially outperform a given benchmark. However, I would add this is a structure that is really only suited for tax exempt investors like pensions, endowments, or foundations.
When building a program there are a few things to consider: the correlation between your hedge fund portfolio and the beta you want to replicate, alpha by asset class that you are giving up by transitioning to a portable alpha structure, the average funding costs associated with the beta you want to replicate, and cash management around drawdowns. For beta replication you’d ideally select an asset class that doesn’t have any correlation to your hedge fund portfolio, one with low expected alpha, low volatility, and modest drawdowns (easier cash management), and one that is cheap to replicate. For that reason, at RSIC, we used our fixed income allocation as the asset class to run portable alpha. What we found was that fixed income managers offered pretty reliable alpha, but it was quite low and generally explained by common factors like credit risk and duration. A top quartile core bond manager has also historically delivered less than 1% excess returns.
Ultimately, the juice wasn’t worth the squeeze. A fixed income beta replication also has the benefit of being naturally lower volatility than equities, credit, or commodities and it’s also more likely than other asset classes to generate liquidity in a stress period. A lot of the people who got into trouble running portable alpha during the financial crisis were using equity futures alongside higher beta hedge funds. We also ran a very conservative ratio of hedge funds to fixed income notional which allowed for a drawdown twice what we’d ever seen in bonds before needing to tap our HF portfolio for cash and liquidate at the wrong time. Lastly, make sure you have a low beta balanced book diversified across as many assets, styles, and geographies as you can while paying particular attention understanding how they perform in stress periods when building a portfolio.
I would close by sharing there are several ways to implement a portable alpha program. You can run a self-directed program with futures like we did at RSIC, you can free up cash and utilize total return swaps on hedge funds, you can employ managed accounts to gain even more cash efficiency, or simply have managers replicate the beta for you and provide a beta plus alpha composite.
What are some of the areas you focus on when selecting an asset manager?
Given my prior focus on hedge fund strategies, I have a data-first approach. Step one is to separate alpha and beta. Investors are often impressed with strong total returns, especially in private markets or long short strategies, but it’s important to understand the market, factor and other exposures that have driven returns. Grouping with a similarly managed peer universe is also another straightforward way to understand if it was skill or beta driving returns. From there I want to understand how those returns were generated – I examine the magnitude and frequency of past trades (I have a preference for many small/medium wins over a few home runs). Ultimately, I want to see statistically significant alpha after adjusting for beta, style, and factor risk.
Next is trade and portfolio construction. I’ve found many people have the same views but the managers that are most successful, maximize outcomes when they are right and have learned to mitigate losses when they are wrong (usually through some combination of options, tactical trading, stop losses, or RV trades). They have a slightly better hit rate but much better skew. On the portfolio construction side, I like to see managers that intentionally force diversification in their portfolios and put on positions that should profit in a variety of scenarios (especially those when they are wrong). Then there are the more obvious things – specialization, repeatable process, self-control, engrained risk management philosophy, limited AUM growth, strong back office, reasonable fees, and no big changes in the competitive marketplace.
What’s your greatest professional accomplishment?
The thing I’m most proud of is restructuring and implementing South Carolina’s $5 billion portable alpha program. We spent a year researching and designing the framework and subsequently reallocated over $3 billion. The program materially outperformed broader hedge fund indices and peer programs and we also added $1.4 billion in excess returns. For the last two fiscal years, we annualized just shy of 15% per year with no beta and a Sharpe ratio averaging between 3 and 4. From all the data I have access to, we were a top decile performer with bottom decile risk and beta. I also think the tools, systems, resources, and partners were as good as anyone in the industry, including dedicated HFoFs.
This was particularly important to me because I grew up in South Carolina and my entire family lives there. I’ve always felt I had a personal debt to the state for the free education they have provided and over the last few years my role provided an opportunity to pay that back.
What do you like to do outside of work?
Reading, cooking, and listening to live music. My wife and I also like to travel. We actually met in Guatemala, and because we were long-distance I joke that our first date was a week in Ecuador, and our second was traveling through Europe for three weeks. Since joining MEMCO, we have really enjoyed exploring Oklahoma City and the central U.S.
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