As pension plan sponsors are well aware, most of a plan’s risk is in its asset allocation. So why don’t more plans spend more time managing that risk?
Arun Muralidhar, co-founder of Mcube Investment Technologies Inc., worked for the World Bank Group’s pension fund in the 1990s but left the role before the tech bubble burst. “And when the tech bubble blew up, I was calling up my colleagues saying, ‘Please don’t rebalance back to that strategic portfolio that I put in place because it’s no longer correct or relevant given the current market situation,’” he says.
Taking advantage of technology
This inspired him to focus on working with pension funds’ chief investment officers to help them manage asset allocation dynamically, he adds, highlighting it’s not just about managing risk, but there’s an enormous amount of value to be captured through a plan’s investment structure.
Generally, pension funds have a strategic asset allocation and are allowed to go over or under a certain per cent from that asset mix. “And very few institutions have formally sat down and said, ‘Well, that plus or minus five per cent, or plus or minus ten per cent, that I might have around the strategic is an opportunity to add value, but also to manage risk if I do it well,’” says Muralidhar.
He notes most plans take no action when they’re within an acceptable range, but they transition back when the asset allocation drifts over that range. “And that’s essentially where the lightbulb came on, was after the tech bubble, it just struck us that not enough people are helping CIOs of pension funds use that discretion that they’ve been given to add value and manage risk on the single biggest risk of the fund.”
As a solution, Muralidhar has built a technology that allows pension funds to test various investment scenarios and find out what these would mean for their plan. “Literally, what we built was an internet-based platform that allowed you to test an idea in no more than one minute, without having to have any programming skills,” he says.
After a plan sponsor tests out ideas, it can program those it likes as ‘rules,’ notes Muralidhar, likening this to a GPS for a pension portfolio. The software will track the rules and, when one is triggered, it will be flagged so the plan sponsor can make a decision on whether to make changes or stay the course.
“We were trying to put discipline into the investment process around saying, ‘Make decisions based on a robust analysis. Once you’ve done your analysis, let the software do the dirty work of tracking it for you and just tell you what your ideas would result in for the portfolio today.’”
Case study
Muralidhar co-authored a paper highlighting how pension plans can use knowledge management and technology, which featured a case study of the San Bernardino County Employees’ Retirement Association pension fund, which implemented a rebalancing program in 2006. The paper’s co-authors were Sanjay Muralidhar and Donald Pierce.
The SBCERA had about $10.3 billion in assets under management as of Oct. 31, 2018. Between June 2006 and October 2018, this informed rebalancing increased the total portfolio return by 1.24 per cent per annum, or about $985 million in added value since its inception.
The way to know added value was tied to the informed rebalancing is because the positions were implemented using futures, Muralidhar says.
When implementing the new system, the board didn’t want to change the turnover rate of the portfolio, says Pierce, who is also CIO of the SBCERA. “And so they effectively said, ‘If you’re going to replace the plus or minus three per cent range base rebalancing that we currently have, it can’t be with something that trades a lot more than that,’” he says.
The SBCERA followed this criteria during implementation, so it interacted with the market at the same rate as before, but did so through decision processes instead of letting the market move it around, says Pierce.
The paper also highlighted that a key part of this program is ensuring a staff member is responsible and empowered to take over the process. During the time the program was in place at SBCERA, the plan also experienced senior staff turnover, but this didn’t affect the informed rebalancing program.
Using a knowledge management tool for rebalancing helped turn data and knowledge into a rigorous and repeatable process, the paper said.
Late 2018 was a reminder
While this idea isn’t new, the end of 2018 was a reminder about the risk of asset allocation, says Muralidhar. “I think 2018 really awakened people to the risk of asset allocation because one of the challenges you have is if the Federal Reserve bank in the U.S. and all the central banks are lowering rates and sort of propping up the stock market, then just having your regular portfolio you have a pretty sizeable return, so you don’t need to work a lot harder for it.
“But I think in 2018, when people’s portfolios had a negative return because the underlying assets underperformed, that’s when a program like this — if it generates positive value — is actually helping you improve your overall outcomes, and it’s also risk management.”
It’s difficult to find returns and plans need to step out of their traditional boxes, he says. “And this is an easy one because it doesn’t require you to fire any manager, it doesn’t require you to change a policy, it just requires you to change an existing process that you had.”