ANALYSIS

More beta, fewer managers, improves portfolio efficiency

HESS_CarlA truly diversified portfolio will have 15 separate asset class allocations with an emphasis on beta opportunities and little to no reliance on active management, according to a Towers Watson’s model.

According to Towers Watson, such a portfolio would have a 20 to 40 per cent improvement in efficiency, measured as return by unit of risk, compared to a simple equity/bond mix.

Or in other words, for a comparable level of risk, the expectation is that returns would be 20 to 40 per cent higher.

Such a model would have fewer managers than employed by most pension funds now, with an estimated eight to 12 managers, compared to 25 to 35 in a full active portfolio.

Global head of investment at Towers Watson, Carl Hess, says this type of portfolio can be made up of beta opportunities and does not necessarily need to rely on active management to any great extent.

“What is important with alternative betas is to focus on those that are genuinely different and genuinely diversifying. We would therefore look to exclude, as far as is practical, any beta exposures that we can achieve more cheaply elsewhere in a portfolio. This is of key importance as what we are trying to achieve for our clients is diversification at the right price,” Hess says.

Towers Watson prefers using a bottom-up approach to alternative betas that builds a portfolio on a strategy-by-strategy basis.

It divides the new world of alternative, or unusual, betas into two types:

1. Strategies exploiting asset classes not typically used by most investors, such as reinsurance and volatility strategies and emerging market currency.

2. Strategies that exploit systematic risk premia in conventional asset classes, including value and small cap stocks and macro funds, while merger and convertible arbitrage could be thought of as exploiting an illiquidity premium.

Towers Watson believes, if properly constructed, these new betas should have a strong diversifying effect on a fund’s portfolio.

The firm suggests three new specific diversification opportunities: insurance-type strategies; the emerging market wealth theme; and alternative betas. Within insurance-type strategies it recommends reinsurance, accessed via catastrophe bonds, and other insurance-linked securities.

It also recommends investors increase allocations to emerging markets, via companies more directly exposed to emerging market growth, in areas such as infrastructure or domestic consumption, rather than on large global companies based in these countries.

Emerging market currencies also present an opportunity to exploit productivity growth.

It also views emerging market debt as a more attractive investment than in the past, as more than 70 per cent of the emerging market debt universe is now denominated in local currency bonds, meaning emerging markets are now much less exposed to a currency crisis.

“We believe that emerging market economies will continue to grow strongly, due to a mix of rising productivity, economic and financial reforms, and favourable demographics. However, institutional investors face significant complexity and potentially high fees, if not careful, when trying to build a portfolio that captures this long-term trend and should also recognise the governance implications of following such a strategy,” Hess says.

“Despite recent intermittent, short-lived peaks the equity party really ended as the new millennium began, so a heavy reliance on this asset class would not have been a good strategy since then. While moving to a diversified portfolio is a higher governance approach than a simple bond/equity portfolio, we think the effort is worthwhile for almost all institutional asset owners.”

Example of a Towers Watson diversified portfolio

Global credit 22%
Emerging market debt 3%
Credit default swaps 3%
Alternative beta strategies 6%
Long dated domestic bonds 31%
Property 4%
Market cap equities 6%
Secured loans 3%
Enhanced equities 6%
Commodities 3%
Emerging market equities 2%
Reinsurance 4%
Asset backed securities 4%
Total 100%