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Leveraging the Investment Decision Process: Dynamically Managing Beta and Alpha. Dr. Arun S. Muralidhar Chairman M cube Investment Technologies, LLC 21 July 2005. Set Static Strategic Asset Allocation Using ALM. Hire Managers - PowerPoint PPT Presentation
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Leveraging the Investment Decision Process: Dynamically
Managing Beta and Alpha
Dr. Arun S. Muralidhar
Chairman
Mcube Investment Technologies, LLC
21 July 2005
2
Roadmap: From Static to Dynamic Roadmap: From Static to Dynamic PortfoliosPortfolios
• Traditional approach – Alpha from external managers
• New approach – Add alpha from informed decisions
• Transparency and governance are critical
Dynamic “Alpha”
Management
Dynamic “Beta”
Management
Consider Simple
Rebalancing Strategies
Hire Managers on a Static Basis (incl. Currency)
Set Static Strategic
Asset Allocation Using ALM
3
Client’s Investment Philosophy
• Asset allocation: key source of return
• Ranges will be maintained through a disciplined rebalancing program
• Diversification by and within asset class is the primary risk control element
• Passive alternatives to actively managed portfolios are preferred, especially in highly efficient markets
4
Key Conclusions
• Separating “alpha” from “beta” - Too much focus on alpha, not on beta
• Little focus on impact versus liabilities
• Dynamic alpha and beta management may be more valuable than static alpha
• All portfolio decisions (incl. rebalancing) impact returns and risks; Must make decisions in an informed manner
5
Investment Decision Process (IDP): Many Embedded Decisions
Total Portfolio/Liabilities
LCSCACWI EMG SC
Equity64%
Cash 0%
Alternatives13%
Fixed Income23%
Non US 24%
Domestic40%
Core21%
HY1.5%
Emerging0.5%
PE 4%
RE 9%
Benchmark Misfit Risk
Asset Allocation Decision
Manager Selection and AllocationImportant to manage/monitor each decision and understand
individual and aggregate contribution to risk/return
6
• Passive: Calendar or range-based rebalancing
• Dutch model: benchmark includes drift until range is met or calendar period is completed
• When range hit, go either to range or target or in-between (what happens within range???)
• +/- 3% range for most assets; 4% for RE
• Client policy gives discretion = Tracking Error
The “Old” Static Framework for Beta
7
• Single asset class focus: Optimize information ratio on active managers for a risk budget
• M3 measure shows why this is incorrect (for single and multi-manager portfolios)
• Modigliani2: Could hire a negative IR manager!
• Dynamic management of alpha: Cash flows make pension funds active – already make decisions on who to give money to and when!
The “Old” Static Framework for Alpha
8
• Also means asset class performance will go through cycles – this aspect is often ignored
• Intelligent staff cannot sit by as markets evolve • Managers can have low correlation with others• Manager cyclicality – why fund a manager who is
starting to underperform?• Role of cash flows in implementing DYNAMISM
Understanding Diversification or “Low Correlations”
9
Passive Rebalancing: Can Be “Risky”*
• Buy and Hold: Let Portfolio Drift
─ 0.16% annualized return; 1.09% tracking error
─ Worst drawdown = -2.15% (multi-year period)
• +/-3% range for most assets; 4% for RE**
─ Impact: 0.01% annualized return for 0.21% risk
• Worst drawdown: much lower at –0.43%
*Rebalancing was evaluated from 01/99 – 04/05. Only tested at the highest portfolio benchmark level. Transactions costs (one way) = 15 bps for equity; 10 bps for fixed
income; 0.5% for alternatives
**Range-based rebalancing = if any asset drifts to the range limit, all assets are rebalanced to benchmark
10
“Passive” Rebalancing: Not Cost/Risk Neutral (Cost 15 bps/yr)
Buy and Hold
Ann Ret: 0.16%
Drawdowns!!
Rebalancing
Ann Ret: 0.01%
Source: AlphaEngineTM
11
“Passive” Rebalancing: Not Cost/Risk Neutral (Cost 15 bps/yr)
Buy and Hold
Ann Ret: 0.16%
Rebalancing
Ann Ret: 0.01%
Source: AlphaEngineTM
12
Informed Decisions within Ranges – Dynamic Beta Management
• Portfolio rebalancing is an “active” decision
• Use cash flows to structure fund appropriately
• Investment decision process creates opportunity
• Large cap vs. Small cap (+/-2%)
• Core vs. HY vs. EMG (+/-2%)
• EAFE vs. EMG vs. Small (+/-2%)
Can staff use discretion to create value?Key: Have a robust, transparent, consistent
process
13
Improving the Quality of Decisions
• Test variety of rules to use for specific decisions
• Consistent evaluation and performance metrics
• Many resources can be tapped
• Internal staff – have ideas that are unused
• Research: many articles on when asset classes do well
• Leverage external managers/relationships – Verizon
• Transparency and process key for good governance
“Prudence is Process”
14
Focused on a Few “Beta” Decisions
Total Portfolio/Liabilities
LCACWI EMG SC
Equity64%
Cash0%
Alternatives13%
Fixed Income 23%
Foreign24%
Domestic40%
Core HY
Chose a few decisions to make the pointDeveloped multiple rules to diversify the risk for
each strategy
Asset Allocation - Equity vs FI
Foreign Equity -
ACWI vs EMG
Domestic Eq. - LC vs SC
Fixed Income - Core vs HY
Asset Allocation - Equity vs
Cash
15
Description of “Beta Management” Rules
• Equity vs Fixed Income vs Cash─ Price of Oil; Slope of Yield Curve, Equity Momentum,
“Halloween Rule”; Fed Model─ Annual Turnover was only 5%
• Equities (ACWI vs EMG; Large vs Small Cap)─ Liquidity, EMG spreads; VIX, Yield Curves, Credit─ Annual Turnover was only 5%
• Bonds (HY vs Governments)─ Eq performance and VIX; Yield Curve, Halloween─ Annual Turnover was only 4%
16
Informed Decisions/Managing Beta: Improved Risk/Return *
• Asset allocation level: Keep return relative to “Buy and Hold”; lower risk relative to Rebalancing
• Stay within passive rebalancing guidelines
• Add returns at every level of IDP – alpha compounds
*All Decision regimes were evaluated from 01/99 – 04/05. Transactions costs were higher for sub-asset class level. Decision
making frequency was monthly
Excess Annualized
ReturnTracking
ErrorInformation
RatioWorst
Drawdown Confidence
in SkillSuccess
Ratio
Asset Allocation level 0.16% 0.19% 0.81 -0.21% 98% 57%
Domestic Equity
Foreign Equity
Fixed Income
0.08% 0.19% 0.43 -0.35% 85% 55%
0.04% 0.12% 0.36 -0.21% 82% 53%
0.04% 0.07% 0.57 -0.18% 92% 56%
Source: AlphaEngineTM
17
Comparing Impact on Entire Fund
Excess
Annualized
Return
Tracking
Error
Information
Ratio
Worst Drawdown
Confidence
in Skill
Success
Ratio
Buy and Hold 0.16% 1.09% 0.14 -2.19% 69% 51%
Strict +/-3% Rebalancing 0.01% 0.21% 0.03 -0.43% 53% 42%
Informed Decisions 0.32% 0.21% 1.5 -0.18% 99% 64%
• At total fund level, better return with lower risk
• Drawdown at total fund level is also lower
• Translates into meaningful $$s = $180 mn/yr!
Source: AlphaEngineTM
18
Managing Beta = “Alpha” ($) + Risk Management = Good Governance
Informed Decisions
Ann Ret: 0.32%
Drawdown is ½!!
Rebalancing
Ann Ret: 0.01%
Source: AlphaEngineTM
19
Ideas for “Alpha” Management
• UK vs Euro ex-UK managers: favor mgr in market with a higher interest rate ─ Added 0.37% annualized over a static mix
• Govt. bonds: favor the manager with greatest momentum over last 3 months─ Added 0.27% ann. over a static mix of 4 mgrs
• Convertible Arbitrage vs Fixed Income Arb─ Allocate to mgrs depending on VIX and OAS─ Added return over static with 12% turnover!
20
Dynamic Alpha and Beta Management can Lower A-L Risk
Annualized Liability Return (Benchmark) = 8.2%Note: These results are indicative and were obtained from another fund using the “informed decision” approach ( 2001-2005)
Option Ann. Growth in Surplus
Volatility of Surplus
Prob. Funded Ratio < 105% at y/e
Static SAA -0.72% 6.64% 34%
+ Managers -0.64% 6.59% 29%
+ Rebalancing -0.57% 6.72% 28%
+ Dynamic +0.29% 7.00% 21%
+ Dynamic +0.34% 6.96% 19%
21
Summary
• Many clients focus only on SAA, Rebalancing and Static Allocations to External Managers
• Using dynamism in portfolio can lead to additional returns and lower Surplus-at-Risk
• Dynamism: both managing beta and alpha
• Cheaper source of excess return at total fund level (than any other “alpha” option)
• Easy to adopt by leveraging external relationships
AppendixAppendix
23
Where Should a Fund Take Risk?
12
-1
0
1
2
3
4
5
0 2 4 6 8 10
Tracking error
Exc
ess
retu
rn
Tracking error vs. excess returns (net of fees) US Equity Large Cap
US Fixed Income
High Yield
Non-US Equity EAFE
Non-US Equity EAFE- Japan LiteEmg Mkt Equities
Non-US FixedIncomeUS Equity Small Cap
US Equity Mid Cap
Non-US FixedIncome - Japan Lite
Source: Muralidhar (2001), Innovations in Pension Fund Management
• Consistent with Client philosophy – WHO IS THE MUG?
From 12/87 to 12/97
Contact Information
Name: Dr. Arun S. Muralidhar
Title: Chairman
Company: Mcube Investment Technologies, LLC
Phone: 1-646-591-6991
E-mail: [email protected]
Website address: www.mcubeit.com