Engineering Alpha at scale

Jon, take us back to 2011. What was the starting point when you joined Delta – and what kind of challenge were you stepping into?

At the end of 2011, Delta’s pension was over USD 13bn underfunded at a time when the market capitalization of the plan sponsor was USD 7bn. A second bankruptcy was a distinct possibility. It was clear that it would take operating profits based on the hard work of Delta employees, a dynamic contribution policy from the plan sponsor and a highly efficient and effective investment strategy capable of generating meaningful alpha to get the pension back to fully funded. It’s been a white-knuckle ride at times. But my team has been honored to have been a part of the solution.

How do you think about asset allocation and portfolio construction?

We believe that it is more risk-efficient to apply leverage to a balanced portfolio than to run a traditional 70/30 allocation where the risk is highly concentrated in the equity factor, especially when the consequences of a drawdown could be dire. Applying leverage through derivatives also allows for the separation of alpha and beta, which is a hugely important part of our success. Risk and liquidity management become more important once you incorporate leverage. I think leverage, when used for the purpose of a higher Sharpe ratio and more diversification, is the most underutilized tool among asset allocators.

Let’s talk hedge funds. How did you structure your portable alpha program, and what role does it play today?

A fundamental target from the very beginning is that we needed 200 bps of alpha annually, and pretty consistently, to increase the odds of success in getting the pension on a more stable footing.

One consequence of being deeply underfunded is that your spending rate is high, which limits how much you can have in private assets. Long-only stock and bond managers have a mixed track record, so we used hedge funds in a portable alpha context to aggressively pursue benchmark outperformance. We don’t view hedge funds as an asset class, but rather as an ideal source of active risk. We use derivatives to synthetically replicate 50% of our asset allocation. We pair that with 10% cash and 40% hedge funds. If hedge funds can outperform the implied borrowing cost by 300 bps you get 120 bps of plan-level alpha. We have exceeded this pace over the past 12 years through a diversified basket of about 40 market-neutral hedge funds. 

What about private markets? How did they contribute – and how did you manage risk across such an illiquid allocation?

Given our spending rate, we are sensitive to the duration of a private portfolio. We have a 25%- 30% allocation to diversified private assets. We target 13% private equity, 10% private credit, and 6% private real assets.

In addition to the shorter duration nature of private credit, we also implement private equity and private real assets using 50% primaries, 30% secondaries, and 20% co-investments. This mix was helpful in mitigating the J-curve (or the tendency to experience negative returns in the early years of a closed-end fund’s life) and served to accelerate the return of cash flow. We target the outperformance of public markets by 300 bps. At a 30% allocation, this is an additional 90 bps of alpha and, when combined with portable alpha hedge funds, we get to our 200+ bps total plan alpha.

The 2020 COVID crisis must have tested everything. How did the portfolio hold up, and what did you learn?

In the early days of Delta’s pension turnaround, our derivative overlay hinted at risk parity but was tilted toward equity exposure.

Delta has done a great job of diversifying its revenue streams as an enterprise, but the airline business remains volatile. We expected there might be a correlation between an equity market drawdown and Delta’s free cash flow. So, we prioritized hedging and liquidity management when our plan-level equity beta was above 0.5.

There were four major components to our hedging program that combined to have an 8% allocation. We had a 60-bps annual spend budget for direct hedging, which was typically 90/75 put spreads. We owned out-of-the-money call options on two-year Treasuries, which was a tail hedge for our liabilities and an indirect crash hedge for equities. We also worked with a few long-volatility managers that tried to balance the convexity vs. bleed trade-off. Finally, we had several separately managed accounts with trend and macro managers.

COVID certainly stressed the program, with equities down 35% in five weeks and Delta’s revenue down over 90% as travel nearly ground to a halt. But the hedging program worked. We liquidated the option-based strategies for huge gains in late March 2020. We also completely unwound the long-volatility portfolio after greater-than-expected gains. We liquidated about half of a commodity trading advisor (CTA)/macro SMAs to shore up liquidity. We were able to hold on to all intended alpha and beta and finished the year with solid returns and alpha as markets came back.

It was a dicey time, but the plan worked. We added a line of credit to the hedge fund portfolio as an additional degree of freedom to help with future drawdowns. 

Governance seems like a recurring theme. What made Delta’s governance structure so enabling for this strategy?

If you are going to run a portfolio that is somewhat atypical and has an element of complexity, it is essential to have all stakeholders aligned on strategy and governance. I’ve been very fortunate to have that at Delta. The chief financial officer (CFO) hired me and was my boss. My team devised the hedging program alongside the CFO and the president (now CEO) of the company.

The mantra for Delta’s governance has been to define success (and be consistent; no moving the goal posts) and build guardrails around the process. Subject to these rules, my team has a tremendous amount of discretion to manage the portfolio on a day-to-day basis. This was crucial during the COVID period. We define success through ex ante alpha targets and tracking error/information ratio estimates for every investment we make, as well as every composite. This includes hedge funds. In terms of guardrails, we have defined a green/yellow/red zone structure around key metrics, with cash and leverage levels being two of the most important examples.

When facing an unusual problem, it is important to get other perspectives. Delta’s CFO at the time knew that every link in the governance system didn’t fully understand the pension implementation. He insisted that we work with external strategic partners that could look for weaknesses and opportunities for improvement in our asset allocation and risk management programs. I have been fortunate to work with some great individuals and organizations over the years who were critical in helping Delta engineer the pension turnaround.

What’s next? How are you positioning the fund now that it’s fully funded?

In a sense, the plan hasn’t changed that much since the beginning: a 40% allocation to hedge funds, a 30% to privates, then round out the heavy alternatives allocations with diversifying liquid mandates, and trade a beta overlay on top of the portfolio. That is still what we do today. However, the beta overlay shifted from being equity-centric to being focused on liability-hedging as our funded status improved and our return target fell from 9% to 7%. We don’t hedge nearly as much today since our beta is much lower.

Delta remains a fantastic place to work. They remain open to untraditional solutions. Pension legislation has evolved a lot since the passage of the Pension Protection Act in 2006, in ways that stabilize funding risk and raise the value of pension surplus for plan sponsors. The window is open for a second act at Delta. The path forward is, broadly, either to sell to an insurance company or to try to be the insurance company. Pensions have a regulatory advantage relative to life insurance companies. Delta contributed over USD 11bn to the pensions between 2012 and 2021. I’m hopeful we can use the alpha generation potential of the pension to build a significant pension surplus, which can be monetized to benefit both the plan sponsor and the employees of Delta Air Lines. 

What would you tell other CIOs or allocators exploring alternatives as a core component of their portfolios?

It is an expensive way to manage money, and risk management is critical. It is important to have quantitative and qualitative ways to measure the success of your managers.

Are you getting value, and more specifically alpha, for the fees you pay? How do the pieces fit together? What is likely to happen during a period of stress? How should you hedge? What is the contingency plan? What will you do when things get difficult?

Write it all down and cover the answers with your governance structure frequently. A crisis is no time for education; it is a time for action. I have been very fortunate to have all stakeholders aligned on the direction of pension strategy.

You’ve said you “love” alpha. What keeps that passion alive after more than a decade in the role?

Two things. First, I’ve got a competitive side. I like to win. For better or worse, financial markets attract some of the world’s best talent in a highly competitive and dynamic environment. I love the challenge of implementing a differentiated vision that I think is capable of materially outperforming benchmarks and peers over time. There is a scoreboard every month and every year. I like the mental challenge of being able to speak to some of the very smartest people in the world daily. I think our information ratio will compare very favorably to most asset allocators.

Second, I am humbled by our mission. My team is also charged with overseeing the investment choices of Delta’s 401k plans. Combined, our team helps manage USD 55bn on behalf of nearly 250,000 past and present Delta employees. We are in the retirement business. The decisions we make can impact the timing and quality of retirement for these employees. It is an awesome responsibility and one that we don’t take lightly. After 14 years, you can see alpha make a difference in the lives of people around you. 

Looking back, what are you most proud of in this journey – and where has innovation played the biggest role?

It’s always a people business and a team sport. I am continually amazed by the dedication and professionalism of my team at Delta. The core of the team has been together since the beginning, through the good times and the bad.

Every voice has been critical, especially in the high-stakes early days of the turnaround. How do we tell the story? How do we design the materials to make complexity simple? How do we keep stakeholders aligned? Perhaps most importantly, when am I wrong? Or, where is there a better way to invest the assets? I try to inspire a culture of constructive conflict. I am tremendously proud of my team, their creativity, their attention to details, their consistent excellence and their ability to make me look good.

It is hard to innovate in institutional investing, and I’m not sure we have at Delta. Weyerhaeuser ran portable alpha well before we did. But there is something to be said for the subtle innovation that is required to run one of the largest portable alpha programs through some trying times. I think it is the scale and longevity that sets us apart. I think there is innovation to our hedging and our risk and liquidity management. I think we have pioneered strategies and implementations to improve capital efficiency. The pods (investment shops that allocate capital to multiple portfolio managers) have been some of the most successful investors in history; there are lessons to be learned.