The critical role of asset mix in driving both performance and risk is inescapable. The trick lies in finding the right balance between defence and offence. Bonds in an asset-liability portfolio primarily play defence. They are fixed income instruments generating cash flows to roughly coincide with fixed income-like liabilities. To the extent a perfect match is achieved, risk is entirely removed on that portion of the portfolio. To perform its defensive risk management role adequately, the bond portion of the portfolio must duration match liabilities with some precision.
Equities in a traditional asset-liability portfolio play offence. They are held to generate a return over the cost of liabilities. Risk management considerations should be efficiently diversified across a number of premium bearing, risky asset classes. Investors should be careful not to arbitrarily exclude asset classes such as real estate or commodities whose low correlations can reduce risk. Nor should investors ignore stress scenarios. The recent market pullback is an instance of multiple exposures declining together: equities, credit, commodities, and interest rates. When designing the return generating portion of their portfolio, volatility and stress scenarios are both considerations.
The other aspect of offence is alpha—returns earned in excess of the market. Traditionally active managers are hired to provide alpha. In all market environments, alpha helps. The increase in compound return positive alpha adds over time can build a valuable buffer against the surprises the market inevitably delivers. Best results are obtained when alpha is sought from the highest quality sources often involving markets or strategies new to pension funds. It is for this reason that portable alpha represents an important step in portfolio construction. It allows the best alpha from various sources to be added to the performance generating portfolio without introducing excessive risk or unwanted incremental market exposures. Portable market neutral hedge fund alpha is an example.
Turbulent episodes are a feature of the markets inhabited by plan sponsors. But there are actions that can be taken to prepare portfolios. The bond portion of a portfolio should be structured as a duration match to liabilities. When the bond portfolio is properly constructed, all the targeted risk will arise from the return generating portfolio. A plan sponsor would want to use that risk as efficiently as possible. The more efficient the return generating portfolio the greater weight it can take in the total portfolio. Diversify the return generating portfolio across asset classes to reduce risk and don’t overlook the risk reduction available from low correlation, premium bearing assets. Make the most of your alpha. The increase in compound return can help to build a buffer against uncertainty. Portable alpha is a tool increasingly used to help pension funds meet their alpha objectives. Quality alpha can lead to a quality result for markets that are influenced by the turbulence of world politics.
Adrian Hussey is a vice-president and head of quantitative research at Northwater Capital Management in Toronto. ahussey@northwatercapital.com
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