Smart beta: Collecting the premiums
By any standards, Pensionskassernes Administration (PKA) has a forward-thinking portfolio of assets for the DKK195bn (€26.1bn) invested through its five pension funds for Danish public-sector social and health employees.
Its real-asset holdings include a number of infrastructure funds and no less than 21 funds allocating to timberland assets around the globe. Its fixed-income portfolio extends beyond investment-grade, high-yield and emerging markets and into leveraged loans and US mortgages.
However, perhaps the most exciting work PKA has done over recent years has been with the least exciting asset class, but the one that takes up the biggest share of most pension funds’ risk budget (50% of the downside risk budget in PKA’s case): equities.
It was here, through 2011-12, that PKA and advisers including Deutsche Bank, JPMorgan and AQR, set about identifying alternative sources of risk and return in equity markets and designing systematic strategies to extract them, alongside more traditional-looking exposures to developed, emerging, frontier and small-cap markets.
They came up with about 15 of these sources of return. Some look like what is now called smart beta – the apparent excess return to low-volatility portfolios, for example, or factors like value and momentum. Others are more like the systematic risk exposures found in well-known hedge fund strategies, packaged-up with glamour, marketing spiel and 2-and-20 fees.
“You won’t see any traditional hedge funds on our list of managers and we certainly don’t pay 2-and-20 for any of this,” says senior portfolio manager Nils Ladefoged. “Many of these managers live a good life off of fixed fees, and we would prefer better alignment of interest. But, in any case, we just generally aren’t very fond of discretionary approaches to markets for risk-premia strategies.”
For now, it is worth pointing out that PKA doesn’t have anything against dumb beta: it describes what it does in developed, emerging, frontier and small-cap markets as “risk premia” exposures, but it doesn’t get too precious or sophisticated about it.
If one really wanted pure exposure to the developed-market equity risk premium, one would have to sell short the risk-free rate as well as being long equities. To get the emerging-market or small-cap risk premia one would have to sell short large-cap developed-market equities. You can see the problem: you would be buying a market in one mandate only to sell it in another, incurring transaction costs for no gain in risk exposure. PKA acknowledges these overlaps and sets about capturing these exposures cheaply and long-only, tracking standard market capitalisation-weighted benchmarks.
• Asset manager and administrator for five defined contribution schemes
• Members: 260,000 in Denmark’s public social and health sectors
• Assets: DKK 195bn (€26.1bn)
What has it done?
After a period of research in 2011 the fund has changed the way it allocates risk and assets in its liquid public equity portfolio. Rather than allocating via traditional regional or sectoral mandates it now allocates to systematic market risks (‘traditional beta’) alongside systematic risks or market ‘anomalies’ that it considers to be rewarded with a return in excess of the market’s (‘alternative sources of return’). The former include developed-market equity risk, emerging-market equity risk and small-cap equity risk, for example; the latter includes allocations to strategies that seek to exploit phenomena such as the low-volatility anomaly or volatility and merger arbitrage opportunities.
This is not to say that the fund doesn’t have some little tricks up its sleeve, even here. A big part of this exposure is implemented via total return swaps, which leaves PKA with lots of cash to deploy in a range of liquidity-providing programmes, like secured funding with banks, which return an average of LIBOR+0.75%. Historically the funding legs of its total return swaps cost about LIBOR-0.25%, and so PKA has achieved its long-only equity exposure with an added return of 100 basis points.
“The most efficient portfolio would be built by isolating all of the different return sources with long/short strategies,” says senior portfolio manager Jannik Teigen Hjelmsted. “That is not practical today, and in any case PKA will always be long-beta to some extent. But we will probably increase exposure to the alternative return sources that are implemented long/short.”
Not all of the alternative returns are extracted by long/short strategies with derivatives. The low-volatility strategy looks similar to many commercially-available long-only minimum-variance strategies. But, just as the traditional beta portfolios are long-only to avoid positions that cancel each other out, here the natural, accidental tilts to factors like value in low-volatility portfolios are managed to avoid doubling-up on risks being taken deliberately in the long/short factor-driven strategies.
Furthermore, the mandates for receiving exposure to factors like value, momentum and quality are run by the same managers to make sure that they are aware of, and avoid, trades that would cancel each other out – crucial because these factors are so often negatively correlated.
So far we have not strayed beyond the world of traditional beta and smart beta. Now we will look at three strategies that are derivative-specific or what we might call hedge-fund beta.
The first is merger arbitrage, a well-worn hedge fund strategy that involves buying the stock of a company being targeted for a merger or takeover and selling short the stock of the acquiring company. Holders of these positions are theoretically collecting a premium for assuming the risk of a failed transaction, which would probably result in each stock price returning to the level it was at before the deal was announced.
“We have two systematic mandates for merger arbitrage, which both try to build as broad a portfolio of global events as possible,” says Ladefoged. “We think there is a nice long-term risk-adjusted return, although currently the spread is pretty tight.”
The second strategy involves systematically buying dividend futures or swaps, the price of which represent the value agreed between two counterparties for potential dividends from the constituents of an equity index, usually over the period of a calendar year. PKA believes that buyers of the contracts (the receivers of the realised dividends) are paid a premium for two risks: the risk that companies simply don’t pay out the dividends implied by the contract’s price; and the risk associated with the relative illiquidity of the contracts themselves.
“One can compare the price on the futures with what analysts’ are forecasting – and typically these implied dividends will trade at a significant discount to those forecasts, suggesting that one is paid a premium for holding the exposure,” Ladefoged explains.
Third, we have a range of equity volatility-arbitrage strategies, implemented with options and variance swaps. The most significant of these involves the systematic implementation of short-volatility, delta-hedged index option positions. PKA simultaneously sells a put and a call on the same underlying, hedging out market exposure and getting pure exposure to implied and realised volatility: realised volatility usually ends up lower than implied volatility, so the holder of this position collects the difference between the two. The premium comes from the risk that something causes realised volatility to out-jump the volatility implied by the prices of the put and call when PKA sold them.
PKA’s total portfolio: DKK195bn (€26.1bn)
• Bonds; swaps
• Bonds and loans
• Investment-grade bonds
• Emerging-market bonds
• Global high-yield bonds
• US mortgage loans
• Leveraged loans
• Real assets:
• Real estate
• Equity risks
• Traditional beta
• Developed-market equity
• Emerging-market equity
• Frontier-market equity
• Small-cap equity
• Alternative sources of return
• Low-volatility equities
• Dividend futures and swaps
• Option and variance swaps-based volatility arbitrage
• Merger arbitrage
• Value, momentum, quality and other factor risks
• Other niche, tactical return sources
• Private equity
• Danish and international private equity
• Direct funds
• Funds of funds
“You tend to see that when equity markets fall, giving you a loss on these short-volatility positions at the same time as you are losing with your traditional beta,” says Teigen Hjelmsted. “This is not a diversifier against our equity exposure, even though the return streams will be uncorrelated outside of periods of high volatility. But the evidence suggests that the premium you can harvest from selling volatility is better than the risk-adjusted return you can expect from equities.”
There is diversification within the volatility arbitrage strategies, however. Against this short-volatility approach (a systematic strategy whose positions are executed by an investment bank partner) PKA also manages two more discretionary long-volatility or volatility-neutral strategies in-house.
The first involves dispersion trades. These are implemented with variance swaps offering exposure to the implied volatility of their underlying securities, and involve selling a variance swap on an equity index (short-volatility) while holding variance swaps on the constituents of that index (long-volatility). Because of the diversification effect, individual stocks’ realised volatility will tend to be higher than that of the index – introducing a potential return from being short-correlation in the position.
The second set of strategies involve selling long-tenor variance swaps, primarily when the market is in distress. The funds are thereby providers of risk capital to the market when it is most needed – and when it is most expensive. In the case of both dispersion and long-tenor variance swap trades, PKA recognises that the sources of return are more time-varying and not so systematic as in implied-volatility arbitrage, and therefore implements positions tactically, executing in-house.
This is an important point that brings us to PKA’s dislike of the ‘smart beta’ terminology; even within volatility arbitrage it carefully distinguishes between premia paid for systematic market risk and sources of return based on more fragile or fleeting market anomalies. Indeed, some of its other alternative sources of return are so fleeting and arbitrage-able – the liquidity-event strategy, for example – that Ladefoged is reluctant to give much away about how they work: PKA is big enough to manage these strategies, but small enough not to move markets as it does so, and he wants to keep it that way.
By contrast, it is common to apply the ‘smart beta’ label to strategies exploiting factor exposures like value and small-caps (which do seem to command a risk premium), but also momentum (where such a premium would be more difficult to describe) and the low-volatility effect (where it would be even more difficult to describe). That is problematic because ‘beta’ always implies a source of systematic risk.
“These are important distinctions because risk premia, while they will be time-varying and sometimes even negative, will never entirely go away,” says Ladefoged. “Anomalies, as the word suggests, perhaps should be arbitraged away as investors price markets more rationally. While we do not believe that, for example, the low-volatility anomaly is about to be arbitraged away, acknowledging that it could be has an effect on how we monitor this kind of return source and our strategies for extracting it.”
So how has this meticulous approach to equity market risks worked out in practice? During 2013, the new portfolio’s first full year of performance, the traditional equity risks returned 22% and the alternative risks returned 13%. “Clearly, if we had put all of our eggs into one basket called ‘Developed Market Equities’ in 2013 then we’d have done better, and moving to this strategy inevitably involved taking some equity beta out of the portfolio,” says Ladefoged. “But what we are getting is, we believe, more robust for the long term.”
PKA is so persuaded of the advantages that it embarked on a second research project to investigate the possibility of extracting value, carry, momentum, volatility arbitrage and the low-volatility effect from markets other than equities. This would extend existing strategies it pursues in commodities and currencies to include interest rates, and would ramp them up to generate a more meaningful contribution to the risk and return of the funds.
In many ways, these markets lend themselves naturally to these strategies. Most have deep and liquid derivative markets and, as Teigen Hjelmsted points out, most are also risk-management markets; unconstrained investors can be well compensated by other market participants looking to lay-off their risks. The same risk-transfer concept underlies several of the premia that PKA seeks in its equity portfolio, such as dividends and volatility risk premia.
“The high-level conclusion was that we do see those return sources outside equities, and we are now working on ways of getting exposure to them,” says Teigen Hjelmsted. “PKA’s investment committee has approved a re-allocation of risk budget to these strategies and we expect by the end of 2014 we will have most in place as we complete the due diligence on each of them. With the same overall risk budget, we think we can earn a higher return for the total portfolio by having exposure to these return sources.”
There are some who would say the job of pension funds is to invest, not to trade or arbitrage risks. Isn’t that what hedge funds and bank prop desks get up to? PKA would respond that no responsible pension fund should put all its eggs in one basket; that the only way to truly understand where those eggs are is to isolate the funds’ risks – and, moreover, that there are some free eggs just waiting to be picked up, and it would be remiss not to do so for its members. That seems like a smart approach to managing money. Just don’t call it “smart beta”.