Investors are taking an increasingly sophisticated view of their passive equity allocations, aiming to capture the benefits of a range of risk premiums, while also lowering the volatility and improving the risk/adjusted returns – all at a considerably lower cost than active management.
Wyoming Retirement System (WRS) turned to risk-premium mandates as part of a broad-ranging restructure of its equity portfolio that began three years ago.
Chief investment officer John Johnson explains that the investment team decided to target 70 per cent passive allocations across major classes. It was a radical about-turn for the $6.5-billion fund, which previously had a preference for active management.
While reducing costs was a benefit of the move to passive, the fund also had the overarching objectives of lowering volatility and improving risk-adjusted returns.
To this end it looked at how to capture different risk premiums – including size, value, momentum and volatility – through tilts to value and risk-weighted indexed mandates.
“We have ranges, so typically between 50 and 70 per cent will be passive in all of the asset classes, with the idea of trending towards 70 per cent,” Johnson says.
Previously, WRS had actively managed all of its equity investments but adopted its passive-management target when revamping its equity portfolio, which currently stands at 53 per cent of the overall portfolio.
WRS decided to use the MSCI risk-premium indexes, focusing on products that would capture the risk premiums of size, value and volatility.
An age of indexes
Large investors are increasingly looking to use these strategy indexes in their passive allocations.
The $42-billion Taiwan Labor Pension Fund (LPF) announced this month that it would allocate $1.5 billion to two MSCI low-volatility indexes tracking global equities and emerging markets.
Other investors to recently adopt MSCI’s risk-premium indexes include St James’s Place and Credit Suisse AG.
MSCI’s New York-based executive director of index-applied research, Raman Aylur Subramanian, says these risk-premium indexes can be used in both active and passive investing.
The multiple risk-premium index mandates can be used to capture a portion of excess return normally associated with active management, leaving active managers to concentrate on stock selection and rotating portfolios to take advantage of market cycles, according to Aylur Subramanian.
Passive investors can use these indexes to either add value to a traditional passive portfolio or access systematic excess returns at a lower cost to traditional active management.
Aylur Subramanian says that investors like Wyoming can make a strategic allocation but the indexes can also be used tactically.
He cites examples of investors who have wanted to de-risk portfolios by adding volatility protection to their portfolio, without the need to increase allocations to fixed income.
They can then rotate between a minimum-volatility index and a traditional cap-weighted index as market conditions change.
For WRS, the passive part of the equity portfolio was split between a 70 per cent allocation to a portfolio tracking MSCI All Country World Index Investable Market Index (ACWI IMI), with the remaining 30 per cent evenly divided between portfolios tracking the MSCI ACWI Value Weighted and MSCI ACWI Risk Weighted indexes.
“What I really wanted to do was capture all of them [risk premiums] without changing the overall portfolio’s factor exposures,” Johnson says.
“If we went and bought a value risk premium, it could change other factors within the total portfolio. MSCI ran various analyses of the portfolio’s risk factors that we were being exposed to. We had an iterative process of what we wanted to allocate to: initially it was one half to market weight and one half to risk premiums, and then of those risk premiums it was split evenly between size, value and volatility.”
Johnson says that the fund ended up incorporating the MSCI ACWI IMI, which encompasses large mid and small-capitalisation segments of the global equities universe, with a 10-per-cent strategic overweight to small caps as a way of capturing the size risk premium.
WRS did not forgo return opportunities via momentum risk premiums, with Johnson saying that allocations to a passive-market cap-weighted index provides a proxy exposure.
“We chose not to use momentum because it was the least understood factor. I think momentum is actually a very good risk premium to incorporate because it is negatively correlated to the other risk-premium strategies, so is useful in a portfolio,” he says.
“But the way we thought about is that, just like we are incorporating the MSCI ACWI IMI to capture the size premiums, effectively the market cap-weight index is a momentum index by definition because, as companies are getting larger and larger caps, they are being included in the index and you are capturing them on the way up.”
Correlation and keeping it Sharpe
Johnson explains that the passive allocation to a typical market cap-weighted index will capture the typical market beta. Hence, correlation will be 1 and the Sharpe ratio will be around the market Sharpe ratio of between 0.2 and 0.25.
Risk premiums aim to increase the Sharpe ratio that would otherwise be expected from a traditional passive allocation. The aim is to generate a Sharpe ratio of between 0.33 to 0.44, [thus] improving the risk-adjusted returns of the passive-equity allocation.
The remaining 30 per cent of the equities portfolio is actively managed, with two-thirds earmarked for long-only managers, Johnson says.
The remainder will be allocated to an “alpha pool” of five-to-seven hedge fund managers tasked with achieving returns that are uncorrelated to the broader market.
“What we have been trying to do is eliminate direct equity exposure and create more nuanced risk exposures across the portfolio,” Johnson says.
In its active equity allocation there is an expectation that the portfolio will have a lower correlation of between 0.75 to 0.8, with a Sharpe ratio of between 0.5 and 1.5, thus generating a higher return per unit of risk than the broader portfolio, he says.
In the alpha pool, zero (plus or minus 0.5) with a Sharpe ratio greater than 1.5 for the total portfolio, will add “an incremental return per unit of risk for the entire portfolio”.
Passivity brings beta
The exposure to risk-premium indexes should only cost 4 to 5 basis points more than the cost of a typical market-cap index, according to Johnson.
The tightly focused approach to active management comes from the investment team’s belief that they should only be paying for more for exposure to areas of the market where there is persistent evidence managers can achieve excess returns over the benchmark.
“If all you are trying to get out of that asset class is beta, then we internally can capture the beta as well as an active manager out there by going the passive route,” he says.
“What we did was that we decided to incorporate the MSCI IMI to capture the size premiums and then allocate 30 per cent, split evenly to volatility and value. So what that did was still kept the overall portfolio-factor exposure very similar to the market-cap index, but it also enhanced the return per unit of risk, which is what we were trying to get to.”
The rest of the revamp
As part of its revamp of the overall portfolio, the investment team has strongly focused on managing and ongoing monitoring of the correlations both within an asset class and between asset classes.
“Because correlations are not static, they change over time, we need to be constantly vigilant on monitoring,” Johnson says.
The restructure of the portfolio has resulted in a 53-per-cent exposure to equities with a target exposure of 50 per cent and a range of 40 to 60 per cent.
Fixed income is 24 per cent of the overall portfolio with a heavier exposure to credit. Fixed income is split 6.5 per cent interest rates, 11.4 per cent credit and 6 per cent to mortgage/opportunistic.
The investment team also added a global tactical-asset allocation (GTAA) that includes global macro hedge funds, risk parity and long-only global tactical allocations.
“GTAA is a strategy to exploit short-term market inefficiencies [in order to] to profit from relative movements across global markets,” he says.
“The managers focus on general movements in markets rather than individual securities within markets. The purpose for our portfolio is to provide a low-correlated asset that will provide high risk-adjusted returns and minimise the volatility of the portfolio.
Real-return opportunities make up 8.5 per cent of the portfolio, with the balance held in tactical cash.
Investments in private equity were recently approved by the board, and keeping with its overarching view on correlations are included as part of the active-equity exposure, as it is essentially capturing equity returns.
The fund also includes private equity-like structures throughout the portfolio with mezzanine and distressed debt forming part of the credit allocation.
Johnson says the fund has not yet set a target range on the amount of private-equity investment.
Infrastructure (1.5 per cent) and real estate (3.5 per cent) form part of the real-returns stream, as will a planned allocation to a resources/commodities, inflation-linked product slated for launch this year.
The fund should complete its equity restructure by mid-way through this year, Johnson says, with the overall portfolio build out being finalised by the end of the 2013.
