Most pension fund investors seek to derive returns from both alpha and beta. However, not enough attention is given to how much of the total risk budget should be spent on these two components and how they should be mixed. Historically, in a world dominated by index-based relative return mandates, beta was the dominant feature of investment manager performance and it was difficult to assess whether alpha was derived from luck or skill. This is logical, as in an index benchmarked world, where equities were the dominant return-seeking asset, splitting the alpha and beta components was difficult. One impact of this is that investors paid too much for beta and, where ‘true’ alpha existed, probably failed to recognise it and its value.
However, certain developments now make it easier to think of alpha and beta separately and to determine how much of each should be targeted, resulting in a greater focus on risk management. In turn funds are now able to match assets and liabilities more closely and then, through a combination of alpha and beta, target returns in excess of the liability returns.
As a result, we anticipate considerable growth in the use of liability hedging and the separation of alpha and beta components prior to their reintegration into a single risk budget as pension funds aim to close funding gaps or reduce benefit provision costs.
Advances in technology now help to deal with liabilities in a significantly different way with the swaps market expanding into long-dated and inflation-linked areas. There is also a blurring of the product offering from investment management firms – hedge funds running long-term mandates, private equity firms moving into hedge fund strategies and traditional investment managers adapting to compete with both.
We have long believed that successful investment must consider the assets and liabilities together as the most efficient asset portfolio would be virtually useless if it did not fit with the liability profile and associated risk budget. This may now mean that the best solution could be to separate out the liabilities, using bonds and swaps, and to design the most efficient asset portfolio in isolation based on what is needed to meet swaps payments and what excess returns are generated. This portfolio would consist of a mix of betas and some alpha based upon the beliefs and governance capabilities of the investor.
At $200,000bn (€151,628.1bn), the swaps market is by far the largest derivatives market in operation, but has largely been the preserve of banks, corporations and hedge funds. However, over the last few years, there has been a rapid development in the market to supply swaps that are attractive to pension funds in terms of hedging their liability risks. Consequently, it is now possible for them to invest a portion of assets in a tailored portfolio of long-dated bonds and swaps, thereby addressing many of the risks of the liabilities. Such matching will help to address inflation and duration risk but its accuracy is limited by the uncertainties of long-term liability profiles. Consequently, regular ‘refreshment’ of the matching portfolio is necessary. No doubt over the next few years better techniques to hedge some of the remaining risks, such as mortality, will be developed. The remaining assets could then be invested in return-seeking assets. This would form an absolute return portfolio where the target is to generate return relative to cash (or inflation). Within this portfolio, alpha and beta would compete side by side for a share of the risk budget.
In addition, as institutional investors move towards more diverse portfolios we need greater clarity about which investments give separate exposures to beta and alpha and which contain non-separable mixtures of alpha and beta. For example, hedge funds would like to claim that their returns are driven purely by skill (i.e. alpha), and yet statistical analysis shows that an investor is actually buying a meaningful exposure to beta (albeit a dynamic exposure). Similarly, in a long-term equity mandate it is clear that there is both alpha and beta risk.
Many pension funds are currently underfunded and a few are in relatively precarious positions given deficit sizes and weakened corporate covenants. So it does appear that the beta from equity and bond markets on their own will not be able to help funds out of their predicament – they “need” to add alpha if they wish to avoid additional contributions, and in practice many are opting for this route.
The key question is whether pension funds are able to add alpha successfully given that positive alpha is likely to remain elusive for the majority of investors. It is therefore critical that they honestly assess their governance capabilities before embarking on this approach. As part of this they should address the pros and cons of ‘insourcing’ and outsourcing governance, given that governance is expandable through partial or total delegation.
As investment becomes increasingly competitive, pension funds need to actively consider as many options as possible that may give them an edge over other investors. With the right governance arrangements in place, the option of considering alpha and beta together in a return-seeking portfolio, separate from the liability matching portfolio, is becoming increasingly attractive.
Paul Trickett is European head of investment consulting at Watson Wyatt.
