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Risks are multi-faceted and evolving: Litterman

If Robert Litterman were a CIO of a public pension plan he would not try to hit an “unrealistic return target”. Amanda White speaks to him about risk, quants, asset allocation and climate change.

There is a serious problem with US public pension funds and the “unrealistic commitments and unrealistic return targets” they have set, says Robert Litterman, co-developer of the Black-Litterman Global Asset Allocation model and risk expert.

“If I were the chief investment officer of a public pension fund I would definitely not increase risk to reach unrealistic return targets.”

The responsibility, he says, is with the entities backing up these promises to recognise there will be significant shortfalls in funding pension benefit promises, but the implications of that have not been acknowledged.

He says chief investment officers managing those assets should not try to hit unrealistic return targets, rather they should understand their risk parameters.

“It is not realistic that equities performance will bail you out,” he says.

Litterman acknowledges there have been advancements in portfolio management over recent years and that investors have been more sophisticated in thinking about their portfolios.

Most notably, he says there is a recognition that risk is a multi-faceted and a multi-dimensional problem. He uses liquidity as an example, noting portfolios are regularly stress tested for liquidity, something that was rarely modelled 10 years ago.

“There is not one source of risk premium,” he says, and timing those different risks makes sense as an opportunity for adding value to a portfolio.

However Litterman says those risk factors need to be actively managed, and he doesn’t believe in a passive exposures to a set of risk factors.

“On average people are holding the market then if you tilt to smart beta someone has to be tilted away,” he says. “Interest rates are an example: quantitative easing is artificially holding down interest rates, so it would make sense to have less than average exposure to interest rates but not everyone can do that – timing different risks makes sense.”

Litterman agrees with the notion there is a spectrum of risk premia with free, unlimited and available market beta at one end, and alpha at the other, and that investors should dynamically allocate to these factors.

Alpha, he says, involves skill, it is not readily known, requires execution capabilities and is usually short run.

“Alpha doesn’t sit around waiting,” he says.

The range of risk premia in the middle is a constant evolution, he says, pointing to the “value factor” as an example.

“The value factor in equities was alpha but now it is so well known and easy to do it’s not alpha, and the risks are greater because of the flows in and out so there has also been a risk/return deterioration.”

One of Litterman’s latest interests is climate risks and he’s a board member of the asset owners disclosure project, attacking climate change from a risk management perspective.

It’s good news for the market, business and society in general. As soon as a quantitative risk manager is involved the prospect of a price for carbon is a whole lot more realistic.

“This is an asset pricing problem. There is tremendous uncertainty and it requires pricing immediately. The reality of climate risk has penetrated to the point there’s little informed discussion but it is starting to sink in, so now what do we do?” he says. “Many people think it’s an ethical issue, ethics and morality doesn’t tell you the right price, science and risk management does,” he says, adding that somewhere between $40 and $60 is about the right price.

Litterman, who is a partner at Kepos Capital and was for many years the head of the quantitative investment strategies group and the global investment strategies group at Goldman Sachs, has spent much of his career around quantitative modelling (he is now also executive editor of the Financial Analysts Journal).

He admits that the returns in the quant movement as a whole was more to do with inflows of assets than fair pricing, but thinks that now quants “are a bit out of fashion, it could be a good place to be”.

His experience is that markets are becoming more efficient over time and with this in mind investors should set a strategic benchmark portfolio and then decide how to manage assets around that.

“If you think you can add value by tactical asset allocation decisions then it’s an avenue for adding value. It is very difficult to do, because markets are pretty darn efficient, but it does provide an opportunity,” he says. “It is hard to be more accurate than the aggregate market view but sometimes things happen like investors over react. It is hard though, and anyone who says it’s easy is probably looking backwards.”

What is possibly a greater consideration for large institutional investors, Litterman says, is the issue of rebalancing a strategic allocation.

“Should the strategic asset allocation be fixed over time? It’s not an equilibrium, not everyone can sell. In deciding to make an active decision to rebalance then you could be being contrarian to the average investor,” he says. “One is not better than the other but it’s important to understand which side you’re on and why.”

It’s a concept that Litterman discussed with Bill Sharpe on stage at the CFA Institute Conference in Seattle this week, on the back of Sharpe’s 2010 paper “Adaptive asset allocation”.

The article proposes an asset allocation policy that adapts to market movements by taking into account changes in the outstanding market values of major asset classes., and avoids contrarian behaviour.