Author: Arun Muralidhar
There is a critical need to find better ways to manage beta than just naively rebalancing to a long-term strategic asset allocation, argues Arun Muralidhar
A tongue twister that all investors should memorize is: “Betty Bought Some Beta, but the Beta Betty Bought was Bitter, so Betty Bought a Bit of Better Beta to make the Bitter Beta Better.” This variation of Carolyn Wells’ original offers sage advice to all investors.
Asset allocation or beta decisions contribute 80%-90% to total fund risk, and good governance requires that beta should be actively measured, monitored and managed. The traditional approach to manage beta in pension funds or endowments has been to hope that diversification protects the portfolio in difficult markets, but that sadly did not work in 2008, and again in the fourth quarter of 2018. With markets wobbling again in 2019, there is a critical need to find better ways to manage beta, rather than just setting a long-term strategic asset allocation (SAA) for five to ten years, rebalancing to it regularly, and hoping that it delivers the desired return with manageable risk. Asset owners must deal with a potentially low-yielding investment environment for the foreseeable future (“bitter beta”), and risks globally are gradually rising again. Another 2008 would devastate pension funds globally.
Traditional rebalancing
Dynamic markets cause a portfolio to drift around its SAA, so when approving a SAA policy, a board also approves allowable policy ranges before a rebalancing is triggered. This policy range is generally viewed from the goal of minimizing tracking error. Traditionally, pension funds implement a calendar, or range-based approach to manage portfolio drift. However, traditional rebalancings are a concentrated tactical decision, often a coin toss and represent arbitrary, reactive decisions based on behavioral biases. Worse, they can actually serve to exacerbate drawdowns in bear markets (i.e., more “bitter beta”) as was the case in 2008. Previous claims that traditional rebalancing approaches were actual strategies- ‘buy low, sell high’, or ‘a form of volatility pumping’- and were also ‘not market timing’ are all easily disproved.
New approaches
At least three innovative institutions, NZ Super (NZ), San Bernardino County Employees’ Retirement Association (SBCERA) and the Verizon Investment Management Company (VIMCO), have recently been reported to have added substantial value, as much as 1% per annum on the entire fund, over periods as long as 10 years, by managing beta intelligently (or alternatively, a bit of ‘better beta’).
In 2005, SBCERA decided to address this drawback in traditional rebalancing and portfolio implementation. The scheme said it wanted to improve governance of the pension portfolio through a disciplined and formal process for asset allocation, similar to what was expected of external managers managing stocks and bonds. Instead of letting a portfolio aimlessly drift until some happenstance rebalancing trigger occurred, a clearly identified staff member was tasked with taking ownership of the beta decision to make adjustments in an explicit, dynamic, and diversified, rules-based manner (i.e., better bets). SBCERA called this approach ‘Informed Rebalancing’, different from ‘Traditional Rebalancing’. It required the staff member to source the best beta ideas from academic journals, so that the ‘strategic tilting’ was based on the best estimate of which assets were over/undervalued, and in turn, under/overweighted within the Board approved ranges.
For its part, VIMCO leveraged its relationships with external managers to ‘crowdsource’ best ideas, while NZS appears to have developed contrarian ideas based on the academic research of mean reversion.
Three elements appear to be common in each of these successful programmes: good governance by Boards and CIOs, allowing decisions to be made internally, and to be patient when these strategies had difficult performance; a staff member (or brilliant Betty) willing to do the research to develop these ‘rules’; and a willingness to provide resources to support these efforts (often much less than external managers’ fees). In many cases, the conditions might not exist to manage these decisions internally. But rather than searching for a brilliant Betty, these same asset owners can find an external beta manager who is given the same restrictions, but essentially serve as an extension of staff to create better beta bets. Further, if implemented intelligently through futures, Informed Rebalancing takes advantage of frictional cash to generate additional cash for the fund (as much as $1billion over 13 years in the case of SBCERA). Moreover, an even better approach to making the bitter beta better would be develop these programs so that they perform extremely well when the bitter beta is being battered by market forces.
These approaches are easily replicable by investors, and each Betty can develop her own bespoke approach based on their objectives and abilities. In short, with a little effort and creativity, brilliant Bettys and asset owners could get paid to manage risk and generate additional cash for their funds through informed rebalancing! To conclude and to offer investors sage advice from Carolyn Wells again, “One never knows what difference anything will make until the difference is made.”
Arun Muralidhar is founder of Mcube Investment Technologies LLC and founder and client CIO of AlphaEngine Global Investment Solutions. He has written extensively on pension reform, asset allocation and currency management. His books include A SMART Approach to Portfolio Management (2011), Innovations in Pension Fund Management (2001), and Rethinking Pension Reform (2004), co-authored with the Nobel Prize winner Franco Modigliani. He has written many award-winning articles for trade journals, and has written a series of Op-Eds with Professor. Robert C. Merton, also a Nobel Prize winner, on innovations to improve retirement security. His latest book, entitled “Fifty States of Grey: An Innovative Approach to the DC Retirement Crisis,” was published in 2018.
*Photography by Princeton Headshots
