Alpha-beta separation is 'future' as trustees alter focus
UK - The pensions industry is on the verge of a "second wave" of liability-driven investment (LDI) strategies, although this time the focus will be the separation of alpha and beta elements, Morgan Stanley Investment Management has claimed.
MSIM said the current stresses on assets and liabilities could trigger a second wave of investment in LDI, although the "side that needs to be built up" is how to achieve the cheapest beta and generate the highest alpha.
Joseph McDonnell, head of Global Portfolio Solutions (GPS) for Europe, Middle East and Africa (EMEA) at MSIM, said: "We're moving in the direction the more progressive Dutch pension plans have gone, with different rules for alpha and beta."
He suggested the traditional approach to asset selection is a "pretty expensive and inefficient way to spread investments" and suggested the separation of alpha - excess returns - and beta - the basic market exposure - will "be the way of the future".
For example, he claimed median manager returns could include some "beta returns masquerading as alpha" so pension schemes are paying higher fees for something they could do themselves.
He warned: "In an efficient market, if you're a decent sized pension fund you will spread your 'manager allocations' out ,which will bring results back down to the median level. And trustee tolerance will change if alpha is not seen to be sufficient.
"There are opportunities, just not in this space [UK equities and fixed income]. In future years we will see much greater emphasis on alpha and the tolerance of trustees will fall, leading to more separation of alpha and beta."
MSIM also argued investors are effectively constraining the outperformance of managers by restricting them to a particular investment universe when they award mandates.
It highlighted in the current environment, where interest rates are falling and causing the costs of pension liabilities goes up, the investment of the pool of assets used to meet the ongoing liability stream "becomes critical".
Justin Simpson, global head of quantitative and structured solutions group at MSIM, said in "stressed" markets outperformance is particularly important. The idea behind separating alpha and beta is instead of starting with a traditional approach and investing in the assets linked to the desired market exposure, the investor starts with a risk budget or target.
He added: "Once this is in place then you ask where in the investable universe is the highest returns for that level of risk, regardless of asset class or whether you want to invest in it."
"Having made that investment, you transform it to a return over your desired market benchmark using synthetic instruments such as derivatives," explained Simpson.
MSIM claimed with this approach a scheme could generate the highest risk adjusted return in one decision but still have exposure to the chosen benchmark through the second decision.
"Instead of asking managers to chase a particular set of shares, this allows them to look as broadly as the investment guidelines allow, to produce the best risk-adjusted returns," said Simpson.
MSIM uses an LDI solution which combines a multi-asset strategy fund and the use of derivatives to achieve the best alpha and cheapest beta in the equity market, although it claimed it could be transportable to almost any asset class with a derivatives market such as commodities, emerging markets and even real estate.
It estimated around $1bn (€641m) is currently linked to these strategies, which MSIM first launched in the UK in the second quarter of 2007, and revealed it is also looking into the possibility of developing this type of fund for real estate, as real estate has an "emerging liquid derivatives market", although it stressed there is "nothing official in the pipeline yet".
Meanwhile, MSIM confirmed the recent launch of GPS in Europe would allow it to target its services at larger organisations such as sovereign wealth funds and foundations, as well as pension schemes.
McDonnell added: "Individual clients are all at different stages of development, so it's a case of trying to understand what their concerns are. We're not competing with actuaries but eventually we're happy to do ALM work [asset liability management] and to start asset allocation work together with other consultants."
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