Pension funds have traditionally set investment strategy by first choosing asset classes and market exposures and then selecting fund managers to implement their choices. However, an alternative approach involves taking market exposures (beta) and manager skill exposures (alpha) together. This can be achieved by creating a liability-matching portfolio and then overlaying it with an absolute return portfolio. The
downside is that the practical issues of managing funds in this way are considerable.
The traditional approach to portfolio construction has meant that pension fund risk has been dominated by market risk, while manager risk has been minimal.
This approach has been criticised recently, and not just because pension funds have been battered by a bear market. Critics find fault with the disciplines used to set the asset allocation. They note that benchmarks include duration, inflation and currency risk exposures that go unrewarded, and that the focus on benchmarks has limited manager skill.
Not a joined-up strategy
They further argue that separating asset allocation from manager skill means that the overall strategy is not well joined-up and relies too much on beta. If market returns are likely to be lower in the future, many funds will want to increase returns from manager skill.
Trends in asset management are starting to chip away at the traditional model. The most obvious has been the growth of hedge funds, which generally rely for their returns on exposure to manager skill rather than to the market. They also provide a good source of returns for ‘porting alpha’.
Before delving into the ‘porting’ of alpha and beta it helps to look at how pension funds are turning to risk budgeting to set investment strategy. Taking a liability proxy (comprising a mix of investible and uninvestible bonds) trustees can quantify the appropriate level of risk for their fund, and apply this to an asset model which gives them an optimal strategy.
They can enhance the asset mix, typically by adding active management. This enables pension funds to implement ‘liability-plus’ mandates by choosing sources of outperformance, such as adding an absolute return portfolio on top of the liability-matched portfolio. In other words, it allows pension funds to ‘port’, or transfer, alpha (returns from manager skill) as well as beta (market returns) to enhance their liability-matched portfolio.
A portfolio that has had market exposure removed relies for returns on its manager’s skill, or alpha. Any active mandate comprises market performance plus the manager’s relative-to-index performance, so the alpha can be isolated using derivatives. One obvious application is in an asset class which is not attractive but offers plenty of opportunities to exploit manager skill.
Examples of ‘porting alpha’ include enhanced bond products that have ‘ported in’ exposures from outside the benchmark universe; enhanced equity index products that have ported in specialised bond and credit alphas; hedge funds that isolate alpha opportunities by hedging out market risk.
Pension funds can use this same technique. First, a liability-matched portfolio is created using a mix of cash, bonds and swaps (even the most closely matched portfolio will still bear some risk). Second, additional alpha exposures are ported onto this portfolio – using one, or a mix of best-in-class managers – with the aim of outperforming the liability benchmark.
From this, we can start to see the benefits of joining up the alpha and beta decisions.
Some market exposure or beta can be included in the return-seeking part of the portfolio in order to improve overall investment efficiency (unwanted exposures can be removed by the use of derivatives).
Reasons for beta
There are several reasons for including beta. First, unlike alpha, betas provide a positive expected long-term return (investors are compensated for taking on the risk of an asset class). Second, betas obtained from derivatives markets; and third, they provide additional breadth of opportunity for skilled managers to manufacture alpha.
Although they are very different, the ‘old’ and ‘new’ approaches to portfolio construction share some key attributes. Both aim to build a mix of alpha and beta exposures that will maximise the outperformance per unit of risk relative to the fund’s liabilities. But in the absolute return approach the alpha and beta exposures are clear and well-defined, and it aims for no risk to go unrewarded.
The downside is that implementation is challenging and so demands a high governance budget as well as a different skill set and mindset. Monitoring can be tricky, and pension fund trustees will need a good understanding of where their money is invested especially as swaps and other derivatives are used. There will be changes in how tasks are delegated, and in the roles of providers (who is accountable for the asset allocation in this structure, for instance?).
New methods of building portfolios that more closely match liabilities are growing popular. A focus on careful spending of the risk budget through joined-up decisions is one such method. Our view is that 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 European head of investment consulting at Watson Wyatt.
