Spending risk in the right places
Most pension funds currently use a two-stage process in determining investment strategy. First, they determine their strategic asset allocation (SAA) using asset liability modelling based on the unique liability characteristics of the fund. This creates the allocation to various asset classes known as the policy benchmark. Managers are then appointed to implement the policy. This may involve the use of active management risk, where the manager uses skill to add return relative to the benchmark.
With this approach, pension fund risk has historically been dominated by market risk. Manager risk has generally made a minimal contribution to the overall level of risk relative to the liabilities. This approach has come in for criticism in recent times. In a sense this would inevitably be the case following a period of weak market performance, but critics are making a number of additional points:
q The disciplines used to develop the market exposures (the SAA) have been relatively weak;
q The SAA benchmarks have typically included a number of duration, inflation and currency risk exposures that were not expected to be rewarded;
q The concentration on benchmarks implied by the approach has limited the breadth of manager skill;
q The separation of asset allocation and manager skill has meant that the overall strategy has not been well joined-up;
q The respective size of the (alpha and beta) risk return drivers are not seen as well balanced; in particular, if market returns are likely to be lower in the future, many funds will want their manager skill drivers to be more influential.
There are a number of developments in the investment industry which are starting to chip away at the traditional model, and allow funds to be managed in different ways. The most prominent has been the growth in the hedge fund industry. Hedge funds are special types of investment vehicles which generally contain high levels of exposure to manager skill and limited exposures to markets. They also provide a good example of what ‘porting alpha’ means.
Before getting on to the porting of alpha and beta it may be useful to and briefly examine the risk budgeting process as an effective method to determine the optimal investment strategy through focusing on risk. The use of risk budgeting by pension funds is becoming prevalent, among other things, as an effective way of optimally mixing risk and return.
It is the risk budget analysis that identifies the liability proxy (an investible portfolio most closely representing the liabilities) and the risk measure which can then be applied to an asset model to determine the optimal strategy. The strategy can then be further enhanced by considering different implementation options – typically by considering how much active management, and the degree of aggressiveness, to add to the mix. This opens up the option of adding an absolute return portfolio on top of the liability matching portfolio. In so joining up the alpha and beta decisions, pension funds would now be in a position to both port alpha and beta and implement liability-plus mandates.
This term refers to any situation where a portfolio has market exposure removed, leaving behind the manager skill piece or alpha. If we think of any active mandate as comprising a combination of the market index performance plus the manager’s relative-to-index performance, by appropriate derivative transactions we can isolate the alpha. The most obvious place where this is valuable is in an asset class where the manager skill opportunities are attractive but the asset class itself is not attractive.
There are a number of examples of this in practice including:
q Enhanced bond products that have ported in specialised bond exposures from outside the benchmark universe;
q Enhanced equity index products that have ported some specialised bond and credit alphas onto the equity index;
q Hedge funds themselves which work to very tight risk controls and will isolate attractive alpha opportunities and hedge out the majority of market risk.
Using this technique to generate returns similar to liabilities with an additional alpha margin, provides a particular opportunity for pension funds and further argues the benefits of joining up alpha and beta decisions. The arrangement is typically offered by one investment manager who has a combination of bond-matching skills and active skills in a number of asset classes. The process undertaken is in two parts. First, a bond-matching portfolio is created. This involves identifying the future structure and timing of liabilities and constructing a portfolio of cash, bonds and swaps that most closely matches those liabilities. Some risk will inevitably remain even in the ideal matching portfolio, given factors such as changes in mortality. Second, additional alpha exposures are ported onto the portfolio creating a mandate that has the objective of out-performing the liability benchmark.
An obvious extension to this approach is to move towards a multi-manager (also known as ‘open architecture’) approach selecting the best-in-class managers in each asset class to improve the effectiveness of these strategies. This reflects the idea that no single manager is likely to have the highest skill level in each asset class.
One other extension is for some market exposure to be included in the absolute return section. The argument would be that the risk return characteristics of certain market exposures might improve overall investment efficiencies. The size of any market exposure could be scaled according to efficiency requirements (any unwanted exposures would be removed by the use of derivatives). As we are adding in market exposure this process is referred to as ‘porting beta’. There are three main reasons why we would want to include a mix of betas in our return-seeking portfolio. First, beta provides a positive expected long-term return (investors are compensated for taking on the risk of an asset class), unlike alpha which is a competitive proposition about gaining at another’s expense. Second, beta increases the available investment capacity substantially and, third, they provide additional breadth of opportunity; skilled managers can manufacture alpha from opportunistically adjusting the mix of beta.
While they may seem very different, the ‘conventional’ and ‘alternative’ approaches share several key attributes, including consideration of the liabilities, and each approach tries to build a mix of alpha and beta exposures designed to maximise the outperformance per unit of risk relative to liabilities. There are, however, significant differences in implementation. The absolute return approach carries the advantage that the mix of risk return drivers can be set directly. However, the principal disadvantage of the absolute return approach is that the implementation is very challenging. Clearly implementation of a complex alternative model will demand a high governance budget.
Monitoring is also a key consideration particularly where pension funds invest directly in the various asset classes and trustees will need to have a good understanding of where their money is invested. The ‘alternative’ approach involves investing indirectly through swaps and other derivative arrangements. This is one of the governance considerations that the trustees will need to consider. Moving to the new approach will require a different skill- and mind-set from the trustees and will involve significant monitoring requirements.
The way governance is exercised would have to change to embrace how delegation is undertaken. This may also involve changes in what the providers do, as the previous demarcations may well not be appropriate. (For example, who is accountable for the asset allocation in this structure?)
New methods of building portfolios which more closely match liabilities are becoming increasingly popular. A focus on risk and careful spending of the risk budgeting through joined up decisions as described above is one such method. We suggest that this approach is radically different from the current method used by pension funds and to be successful will require considerable change to most governance budgets. Our view is that this will become more popular over time, and funds would do well to build an understanding of its strengths and weaknesses now.
Kevin Carter is a senior investment consultant at Watson Wyatt