Timothy B. Barrett, Donald Pierce, James Perry and Arun Muralidhar look at the structure of dynamic beta management and its implications
A dynamic beta programme, effectively implemented through an overlay and custom-tailored to each investor’s needs, can help manage the risk of portfolios from an asset-only or an asset-liability perspective. Dynamic beta provides substantial improvements for traditional investment portfolios, as well as new fads as these approaches carry substantial residual risk that the dynamic beta programme can manage. Dynamic beta is defined as a programme which dynamically allocates to beta assets based on formal rules (as opposed to standard mean-variance optimisation and risk parity approaches which are static), but which has the unique characteristic of lowering the overall risk of the fund – where we define risk not just as volatility of returns, but of the drawdown of the fund – while at the same time earning a positive return. In short, this article proposes a more intelligent, informed approach to managing a portfolio dynamically in order to manage risk and return. It also places the dynamic beta programme within the constraints of typical institutional investment portfolios, by addressing governance and implementation issues.
The two crises in 2000-2010 decade led to a search for new approaches. The first crisis led to the Yale Model and the second crisis led to adoption of risk parity (or equalising risk in a portfolio). The year 2011 is leaning towards another crisis as equity markets have fallen and there is great uncertainty about the value of sovereign debt (traditionally a safe asset). However, both approaches are flawed as they are static. If it is always correct for a portfolio to hold 60% stocks, then valuation does not matter; dynamic beta is different as it explicitly relies on valuation and related market factors that capture the relative attractiveness of assets in the prevailing environment. Funds would be better served by implementing a dynamic beta programme to complement whatever static strategic asset allocation (SAA) approach they take.
Getting paid to lower risk
The idea of a dynamic beta programme was seeded in an intelligent rebalancing programme that was designed in 2005 and implemented in 2006 for a US public pension plan, The San Bernardino County Employees’ Retirement Association (SBCERA). The SAA is an unachievable benchmark as it assumes that the portfolio is constantly rebalanced back to the static weights (though some Dutch funds assume drift), but the actual portfolio drifts away from the SAA every day. SBCERA acknowledged that investment policies were silent about what pension funds should do when the portfolio was drifting within rebalancing ranges or periods. Allowing portfolio drift or naively rebalancing back to the SAA is an implicit and unmanaged bet that could lead to bad performance on total return, and this was borne out dramatically in 2008-2009.
As part of our series looking at what firms did to win accolades at the UK Pensions Awards 2016, PP speaks to Capita Employee Benefits head of Creative Sparks Louise Harris about how the firm won the Communication Innovation of the Year category.
As part of our series looking at what firms did to win accolades at the UK Pensions Awards 2016, PP speaks to the Travers Smith pensions team about how their firm won the Pension Lawyers of the Year category.
In the wake of the Brexit vote, the government has been radically overhauled. Two former pensions ministers tell James Phillips how this affects pension policy.
In May the General Data Protection Regulation (GDPR) was adopted by the European Union, Michael Klimes examines how it will affect UK trustees