Asset owners must deal with a potentially low-yielding investment environment for the foreseeable future.
The traditional approach has been to use external managers to achieve fund goals and hope that diversification allows them to navigate difficult markets, as in the fourth quarter of 2018.
But alpha in many of these strategies has been hard to come by leaving funds trailing their target rate of return over long periods of time. A complementary strategy is to focus on an untapped alpha source to improve returns, risk management and governance.
Rather than focus on security selection for alpha, innovative plans are focusing on the biggest risk in funds – asset allocation or beta – and the permissible ranges around the strategic asset allocation (SAA) to capture substantial added value through “strategic tilting” or “informed rebalancing”.
At least three innovative institutions have recently been reported to have added substantial value, as much as 1 per cent per annum on the entire fund, over periods as long as 10 years – New Zealand Super (NZS), San Bernardino County Employees’ Retirement Association (SBCERA) and the Verizon Investment Management Company (VIMCO).
What distinguishes this approach from others is that this is alpha was captured by informed decision-making by internal staff. Hence costs are low, interests are aligned, and overall governance improved.
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 minimising tracking error.
Traditionally, plans 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 behavioural biases. Worse, they can actually serve to exacerbate drawdowns in bear markets 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.
In 2005, SBCERA decided to address this drawback in portfolio implementation. The CIO noted to the board that, “one goal at SBCERA was to improve governance of the pension portfolio through a disciplined and formal process (for asset allocation), similar to what’s expected of external managers in managing stock and bond portfolios.”
Asset allocation decisions contribute 80-90 per cent to total fund risk and good governance requires that they should be actively measured, monitored and managed. Instead of letting a portfolio aimlessly drift until some happenstance trigger occurs, a clearly identified staff member was tasked with taking ownership of the asset allocation decision to make adjustments in an explicit, dynamic, and diversified, rules-based manner. SBCERA called this approach “informed rebalancing”, different from “traditional rebalancing”, requiring the staff member to source the best ideas from academic journals so that the “strategic tilting” was based on staff’s best estimate of which assets were over/undervalued and in turn, under/overweighted within the board approved ranges.
One could see this as a “Portfolio GPS”, giving the team guidance on how to navigate dynamic markets. VIMCO leveraged its relationships with external managers thereby “crowdsourcing best ideas”, and 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 programs: 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 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). Further, if implemented intelligently through futures, informed rebalancing takes advantage of frictional cash to generate additional cash for the fund (as much as $1 billion over 13 years in the case of SBCERA).
These approaches are easily replicable by other asset owners, and each fund can develop its own bespoke approach based on their objectives and abilities.
In short, with a little effort and creativity, asset owners could get paid to manage risk and generate additional cash for their funds through informed rebalancing.
Arun Muralidhar is co-founder of Mcube Investment Technologies.
