Beta-driven equity investors may currently be taking far greater risks than they are getting paid for when seeking broad market exposure, British risk expert Nick Bullman warns.

Bullman, the founder of specialist risk consultancy CheckRisk, has developed a methodology using macroeconomic research along with econometric and behavioural risk inputs to identify what he describes as risk clusters.

The risk-monitoring process attempts to understand both human perception of risk and how that relates to the actual risk environment.

Monitoring the rate of change in a variety of market variables and, most importantly, correlations is a key driver of the firm’s approach, Bullman says.

 

Post VaR
The result of CheckRisk’s analysis is at odds with the view that investors should get back into the market after the volatility experienced in the later part of 2011, Bullman argues.

“These are not beta-driven markets, and the things that equity markets are addicted to are quantitative easing (QE) and LTRO (the European Central Bank’s Long-term Refinancing Operation), and both these have diminishing-return values because the bond market is taking a different view,” he says.

“Given it is the bond market that has to eventually finance QE and LTRO, they are beginning to ask where the growth is going to come from.”

Bullman reckons investors need new ways of thinking about risk, as traditional risk models – such as value-at-risk (VaR) – have failed to account for outlier events, which can have a devastating effect on portfolios.

“Value-at-risk is a very dangerous tool and using it is like driving down the highway very fast looking into your rear view mirror. You will have an accident, it is just how badly and when,” he says.

VaR underestimates both the scale and frequency of outlier events or what Bullman describes as the quantum of risk. CheckRisk wants to look at these tail risks and see if they are random events or, in fact, related to each other.

It is what the firm is seeing in its analysis of correlations that has resulted in this cautionary note to investors seeking market beta.

The firm monitors 160 risk factors weekly, looking for correlations between these factors and, most importantly, sudden changes in them.

The result is a monthly dispersal index that endeavours to measure how much each of these correlations are “listening” to each other – whether, in effect, markets are behaving in a rational manner.

 

Correlations are key
When markets become highly dispersed, there are two ways CheckRisk believes they can re-correlate.

The first is through a benign re-correlation, a so-called type A re-correlation, which is easily spotted because it is slow and is driven by positive economic data and steady investment flows.

The second or type B re-correlation occurs through a negative-event risk.

“When the correlation matrices are highly dispersed and event risk is high as it is today, we believe that depending on beta is risky because you are likely to be exposed to these type B correlations that occur when markets fall,” Bullman says.

This approach is driven by the view that risk clusters, or that risk can, in fact, create more risk in special circumstances.

Bullman notes that this is counter-intuitive because in benign risk periods, bond and equity markets absorb risk and investors have a tendency to become complacent to new risk events, assuming that risk absorption will continue.

“We are in a long-risk cluster with a potential elongated duration of seven to 12 years. So those depending on market beta to drive returns are taking excess risk, assuming that markets will return to a more normal risk pattern,” he explains.

“What you need to buy is dividend yield, corporate debt, infrastructure and property. Because those things are certain and the cash flows are more dependable and generate a larger portion of total investment return than the previous 20 years.”

While some have argued that investing for income-generating assets is already a crowded trade, Bullman has a different view.

“Saying the income story is a crowded trade is assuming a reversion to mean and the good old days. That is a premature assumption that is not supported by the risk backdrop,” he points out.

Informed by research looking at the daily returns of the S&P from 1928 to 2011, Bullman argues that risk forms clusters, which may become chains of risk, in which one event triggers others along the chain.

These risk clusters can then spread around the system or can “bridge” across the system rapidly – sometimes in previously unexpected ways. Market crashes such as the global financial crisis are described by Bullman as super correlations, as all parts of the risk environment are affected.

“Far from being noise, it [changes in correlation] is actually really interesting information,” Bullman says.

“People struggle when they see correlations changing rapidly because they want to know what to do. What you do is you stand back and say this is unusual, this is not normal, therefore, risk must have increased.”

Along with these correlations, CheckRisk’s analysis also examines the acceleration, deceleration or sudden reversals in direction of risk factors, the absolute level of which also forms part of the overall risk-measurement framework.

 

Revelations of risk
According to CheckRisk’s analysis, markets are currently in a period of increased risk.

Its historical analysis of daily S&P returns reveals that these risk clusters of increased market volatility and risk usually last between three to five years. They are then followed by benign periods that tend to average around 14 years, in which GDP growth is constant and there is a low risk of shock events.

Bullman predicts that this time we are in for an extended period in which risk is elevated and the potential for a large market shock continues to loom in investors’ thinking.

“We think the generation of liquidity by central banks that have expanded their balance sheets from $5 trillion to $15 trillion over the last six years is elongating this risk cluster. It could be as long as 10 to 12 years,” he says.

“That really makes a huge difference to your risk appetite and the kinds of assets you go for.”

While it is perhaps no surprise that a risk consultant would have a bearish outlook, Bullman says that this risk analysis is also a way for investors achieving a more objective view of where they might be in a particular market cycle.

 

Bubble trouble
Along with its work on risk-factor correlations, Bullman says CheckRisk has spent a lot of time thinking about price bubbles and their relation to investors’ perception of risk.

He notes that at the beginning of a potential market bubble, namely after a market shock, investor perception of risk may be quite high, when in fact real risk is low.

Likewise, when a bubble is close to bursting, market exuberance may be high, indicating low perceived risk in the face of heightened underlying risk in the market.

 

Perception versus reality
Another of CheckRisk’s methodologies compares a range of behavioural inputs to broader economic data and attempts to provide insight into the level of perceived risk versus real risk.

The rate of change in a variety of behavioural inputs – such as insider selling, adviser-sentiment surveys, confidence surveys and credit-default-swap pricing or volatility – are monitored.

These are then compared to economic or statistical inputs, such as money supply, velocity of money, bond pricing, TED Spread (the difference between interest rates on interbank loans and on short-term US government debt) and others. The result is a perceived-risk-to-real-risk ratio that can provide an indication of potentially heightened risk.

CheckRisk’s approach has seen it develop strong academic-research relationships with the University of Bath School of Management in the UK. It has recently launched a four-year risk-development program sponsored by the UK government and partnering with Bath and Bristol Universities.

As well as providing a general overview of the risk environment, CheckRisk provides bespoke risk analysis to clients.

Bullman says the consultancy can monitor up to 98 per cent of the risk exposures in a client’s portfolio, providing correlation analysis for a sample portfolio and comparing it to correlation changes in the broader market.

For clients needing to use VaR, the consultancy can also provide what it calls a confidence overlay, which allows for the potential for outlier events that may not appear in the VaR analysis, to be factored in.

“This kind of risk analysis is dynamic and focused on the present,” he says.

“It generates risk discussions around long-term portfolio allocations, about risk appetite and the critical question all investors should ask: ‘Are we being paid to take the risk our portfolios are currently exposed to?’ Just having a risk tool to drive that question can significantly reduce risk.”

 

Funds are looking to increase their allocations to property, with direct ownership of unlisted pooled-property funds the most popular way of gaining exposure, a Top1000funds.com global property survey reveals.

The survey shows funds have an average exposure to property of 9.5 per cent of their overall portfolios and would most likely move funds from equities and bonds to increase exposure to the asset class.

Most of the funds surveyed indicated their allocation to property would either stay the same or increase. While they had long-term plans to increase allocations to non-domestic property, funds still demonstrated strong home bias when it came to property.

Funds that indicated they would increase allocations to property on average would do so by 10 per cent to domestic property, compared to an average increase to non-domestic property of 5.6 per cent.

When it came to investing in property, funds were looking for like-minded investors with long-term time horizons.

“The ideal way to invest in non-domestic property for us as a pension fund would be a non-listed leveraged or very low leveraged fund with a limited number of participants, preferably other long-term investors,” one senior investment staff member told Top1000funds.com.

Conducted in the later part of 2011, the survey garnered responses from 54 funds in 14 different countries representing almost $1 trillion in combined assets under management.

Respondents included Canada’s Alberta Investment Corporation, sovereign wealth funds the Korean Investment Corporation, Ireland’s National Pensions Reserve Fund and Pensioenfonds Vervoer from the Netherlands.

More than 70 per cent of respondents say they plan to diversify into non-domestic property, with the majority seeing little difference in the global approach they take to equities and bonds and the strategy they are adopting in property.

Despite this, property portfolios still have some way to go before they match these diversification goals as the median allocation of property assets was 85 per cent domestic and 15 per cent non-domestic.

The continuing home bias towards domestic property can be seen in the context of last year’s risk-off environment.

The majority of funds consider non-domestic property to be higher risk than the domestic variety. But they also indicated that the rewards were potentially higher in non-domestic property.

Funds also seem more confident about investing in their own backyards. When asked if they had strong knowledge about non-domestic property, the most popular response was “somewhat/neutral”

The vast majority of funds saw the main benefits of investing in non-domestic property as increased diversification followed by increased risk/adjusted returns.

There was also a number of ways funds were choosing to access the asset class. The most popular was direct ownership of unlisted pooled-property funds, with 20 per cent of investors indicating they used or would use this method. This was followed by a fund of listed-property securities or real-estate investment trusts (REITs), with about 14 per cent of investors preferring this method, 11 per cent each going for direct ownership of listed-property securities or REITs and exposure through property debt.

When it came to selecting a manager, funds indicated that they on average ranked investment process as the most important feature followed by experience and performance.

The size of the fund and a consultant’s ranking were the least important criteria for manager selection.

Academics collide on the relationship between environmental, social and corporate governance (ESG), and alpha. One view is there is a clear link that can be uncovered by a deep dive into the underlying factors using a sophisticated operating engine. The other perspective is that the market will price in environmental and social factors, the way it has done with governance. Amanda White speaks to academics with different points of view.

Andreas Hoepner, lecturer in banking and finance at the University of St Andrews in Scotland, says alpha requires a sophisticated investment operating engine to find ESG.

The simple step of taking the ESG data, especially if it is sold to everyone, is usually not adequate to find alpha, he says. But if extra steps are built in, then alpha becomes evident.

“The extra steps are, for example, to look at industry or other types of classifications. ESG factors have a profoundly varying impact on firms, depending on their business model. Environmental management, for instance, has a very different meaning for banks than for oil companies. When you start to build extra steps, you quickly come to some alphas.”

The more competition in the area, according to Hoepner, the higher the level of operating engine needed to identify alpha.

“For example, analysing conventional fundamental accounting information, there is a lot of competition so the engine needs to be highly sophisticated,” he says, referring to the level of information portfolio managers assess in order to find alpha.

Within the field of ESG, Hoepner thinks there isn’t as much need for an engine that is quite as complicated, because there is not as much competition.

“From an investor point of view, when searching for alpha, ESG is a style similar to value investing: you are convinced of a certain type of asset and try to understand where and when it performs best. In the value-investing case, you are convinced by firms with low price-to-book rations, while in the ESG-investing case, you are convinced of firms with more sustainable business processes and a longer term management perspective,” he says. “From an investment-style perspective, at St Andrews we are optimistic that ESG information is not fully efficient as in our research we find many alpha opportunities that cannot be fully explained by transaction costs.”

 

When it comes to the relationship between ESG and alpha, Hoepner highlights the impact of specialist skills, pointing to the 2010 Journal of Business Ethics paper, The performance of socially responsible mutual funds: the role of fees and management companies by Javier Gil-Bazo, Pablo Ruiz-Verdu and Andre Santos.

The study found that in the period from 1997 to 2005, US socially responsible investing (SRI) funds had better before-fee and after-fee performance than conventional funds with similar characteristics, and the differences were driven exclusively by SRI funds run by managers who specialised in SRI.

Further, funds run by companies not specialised in SRI underperformed their matched conventional funds.

“The research found some very interesting outcomes. Specialist funds are clearly better than conventional funds, and non-specialist are worse than conventional funds,” he says.

Hoepner says this highlights a key failing of current investment thinking in that there is a clear mismatch between ESG skill and finance training.

This is also something that asset owners are discovering in their own approach to ESG integration.

 

The CalPERS case
The investment office of CalPERS, for instance, now has set implementing ESG as a strategic goal and its board is committed to this.

But Anne Simpson, director of corporate governance at CalPERS, recently said that it won’t work unless it can get the F – as in finance – into ESG.

Hoepner believes there are inadequacies in using only financial accounting data in financial analysis, as corporate accounts are conceptually an estimation and they are more relevant in the valuation of some companies, such as Fedex, than other companies that trade at large multiples of their book value, such as Amazon.

He believes it is also important to assess non-tangible factors, such as management quality, and this is an opportunity for assessing whether alpha exists.

“There is an enormous opportunity to incorporate intangible factors in a responsible way in financial markets,” he says. “You speak to people in other industries such as engineers or computer scientists and they say it is obvious that intangible factors affect consumer decision making and so performance. Just financial economists have possibly believed their own theories of the hyper-rational homo economicus in the consumer and also the analyst a little too much.

“We are very optimistic ESG alpha exists, but you can’t get ESG from one nice, level approach. But if you combine ESG metrics with very sharp statistics you can find alpha.”

One of the faults, according to Hoepner, is that analysts either look at financials and then ESG, or ESG and then financials.

“I think there’s way too little of both together. If you focus on one, then you miss the other. Bringing the two drivers together can be powerful,” he says.

“It is important to compare ESG investment to other styles when you want to do financial analysis, otherwise it is treated like a step child.”

Hoepner points out that when it comes to portfolio and strategic decisions, there is more to it than just alpha – client loyalty and the universal owner hypothesis come into play, and trust becomes very important.

 

What is relevant will be priced
Unlike Hoepner, Rob Bauer, professor of finance at Maastricht University School of Business and Economics and director of the European Centre for Corporate Engagement, thinks that markets have already priced in some of the relevant ESG information.

“By simply buying good ESG companies, you do not necessarily make good returns in the long run,” he says. “Especially, information on G (governance) is properly priced to a large extent. It might not be at that stage yet for E and S, but I strongly believe that market participants are gradually pricing the relevant information pieces, and they certainly will in the next decade. So there will be no information advantage.”

Bauer points to the study by Harvard academics, Lucian Bebchuk, Alma Cohen and Charles Wang: Learning and the disappearing association between governance and returns.

The study looks at the relationship between returns and a governance index, constructed on the basis of 24 governance provisions that weaken shareholder rights. During the 1990s there was a clear governance-returns correlation, which then disappeared in subsequent years.

The paper provides evidence that the existence and disappearance of that correlation were due to market participants’ learning to appreciate the difference between well and poorly governed firms.

It found that the disappearance of the governance-return correlation was associated with an increase in the attention to governance by a wide range of market participants; and until the beginning of the 2000s, but not subsequently, stock-market reactions to earning announcements reflected the markets being more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms.

“The Bebchuk study confirmed the results of the Paul Gompers study in 2003, which found that in the 1990s well governed firms performed better than poorly governed firms. The Bebchuk team redid that report and now finds that good governance (especially information on takeover defences) is fully priced into stocks.

Probably, the same will happen with E and S, but it will take some time to figure out which information is relevant for cash flows and the volatility of cash flows of firms,” Bauer says. “I think it is not clear yet, but it is becoming clearer. In the end, what is relevant will be priced; what’s not relevant is simply not relevant.”

 

Engagement also starts with E
Bauer believes engagement is the only sustainable way of responsible investing.

“There is a need for a collaborative investor community to engage and change practice on relevant issues in both the financial dimension and the ESG dimension. This will then change the valuation of these companies and lead to higher returns.

Both Bauer and Hoepner are previous winners of the French Responsible Investment Forum, which supports promising research and significant academic achievements and is endorsed by PRI.

Jean-Philippe Desmartin, who created the awards in 2004 and who is the head of ESG research at Oddo Securities, says ESG research is scant.

The awards aim to promote in the long-term academic research with finance and ESG in Europe, he explains.

The genesis of the award came in September 2003, when he saw Harvard’s Michael Porter speak at Copenhagen Business School and identify ESG as a key subject for companies.

“He said it was a top-10 issue for the following decade… and there needed to be more professionalism, to deliver academic research not just to show convictions.”

Desmartin believes that in practice integrating ESG is not completely different from other fundamental analysis.

“Analysts want to understand management, products and services as well as financial statements and fundamentals,” he says. “At Oddo, we are convinced from ESG research you can get alpha.”

There are a number of awards, and this year the winners will be announced at the PIR-CBERN Academic Conference 2012, Evolution of Responsible Investment: Navigating Complexity, to be held from October 1 to 3 at York University in Toronto.

Korean corporate pension funds have grown more conservative in their investments, increasing already high allocations to guaranteed-insurance contracts (GICs) and term savings, the Towers Watson Korea Pension Report shows.

The annual snapshot of the Korean pension market found that 93 per cent of corporate pension-plan assets are allocated to principal-guaranteed products, of which nearly 58 per cent is invested in cash instruments.

Guaranteed-insurance contracts are insurance policies that promise a fixed or floating interest rate during the policy period.

Jayne Bok, Towers Watson Korea’s director of investment services, says the research indicates a 5-per-cent increase in allocations to principal-guaranteed products last year, indicating the high risk-aversion among both Korean pension-fund sponsors and members.

Much of this increase was caused by significant mandates, mostly invested in GICs, being awarded to two service providers from defined-benefit plans affiliated to them.

“Last year was a bit of a risk-off environment so the service providers who were doing the asset allocation were more conservative, and putting more into cash and bonds than they were into equities,” Bok says.

“There are restrictions that don’t allow you to invest that much in equities to begin with… But the problem is more the starting point, rather than anything that has happened in any particular year. Any kind of risky environment you could see will trigger the same response. The baseline level of risk tolerance in Korea is basically too low.”

Bok believes this conservative allocation is largely influenced by corporate sponsors’ “cash-reserving mentality”, which finds its roots in legacy severance schemes and recent fierce competition among service providers offering attractive or inflated interest rates to attract new clients.

“As a result, there is also an inappropriate focus on capital preservation rather than on income or return generation, which would be more suitable given allocations should be focused on the ability to pay pensions in the longer term,” she says.

 

Regulation and return-seeking assets
Further encouraging conservative investment approaches are government restrictions on defined contribution and individual retirement account (IRA) schemes limiting investments to return seeking assets such as equities.

This conservative approach is at odds with larger public pension funds, such as the National Pension Scheme of Korea, which is in the midst of a four-year program to double its holdings of international equities.

The country’s sovereign wealth fund, the Korean Investment Corporation, under former chief investment officer Scott Kalb, started a five-year plan to double its allocations to private markets, in particular looking at distressed-debt opportunities and real estate.

Corporate pension funds have, however, taken a safety-first approach, preferring principal-guaranteed products.

These GIC providers in the last year have offered interest rates on principal guaranteed products in a range of between 4.21 and 5.1 per cent, Bok says.

Bok points to wage inflation in 2011 as being around 5.5 per cent, based on Towers Watson’s annual compensation surveys, re-enforcing the need to seek better performance than the cash rate.

She expects a rationalisation in fixed-rate products and a gradual lowering of interest rates offered to drive a gradual push to more return-seeking assets.

The pool of $45 billion in Korean corporate pension plans includes both defined-benefit and defined-contribution plans.

 

Guarantees over growth
With funding levels for corporate defined-benefit plans typically around 70 to 80 per cent, funds adopting conservative investment approaches are unlikely to improve these, Bok notes.

Korea adopted a funded pension-plan system similar to those of developing countries in 2005. Bok says the relative infancy of the system also contributes to conservative investment approaches.

“Sponsors and members need time to increase their investment literacy before we can expect to see fundamental changes in their investment behaviour,” according to the report.

Plan sponsors have been focused on whether to adopt a plan and choosing a service provider, with little thought going into the ongoing investment strategy.

“From a chief financial officer’s perspective, if the pension plan costs are less than 1 per cent of your book, you don’t worry too much about how you are going to invest the assets. It is simple to write an insurance contract for a GIC because you then have no worries because someone else is guaranteeing your return,” Bok says.

“So, I can understand why at this early stage of the market we have this kind of behaviour, it is always easier to stick to the current practice than do something different.”

The report reveals that total pension assets grew by 71 per cent in 2011.

Bok says that as this recent exponential growth continues and pension plans loom larger on the balance sheets of companies, it could trigger changes in investment approaches as plan sponsors pay more attention to fees and performance.

Authors Christopher Armstrong from The Wharton School University of Pennsylvania, Ian Gow of Harvard Business School and David Larcker from the Graduate School of Business Rock Center for Corporate Governance, Stanford University, look at the efficacy of shareholder voting.

The study examines the effects of shareholder support for equity compensation plans on subsequent chief executive officer compensation.

Using cross-sectional regression, instrumental variable and regression-discontinuity research designs, the authors find little evidence that either lower shareholder voting support for, or outright rejection of, proposed equity-compensation plans leads to decreases in the level or composition of future CEO incentive compensation.

Click here to read The Efficacy of Shareholder Voting: Evidence from Equity Compensation Plans.

 

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.