Risk Budgeting and Dynamic Asset Allocation

story_images_icebergAs a speaker at this spring’s Global Investment Conference in Banff (April 5 – 7), Jeffrey Scott, Chief Investment Officer at the Alaska Permanent Fund Corporation, will be sharing his views on how risk budgeting and dynamic asset allocation interact with strategic asset allocation. In advance of the conference, we asked him to answer questions on how these are applied at the Alaska Permanent Fund.

Q: What risk factors do you single out?

A; We go quite in depth, but we start by constructing our portfolio based on five primary risk factors: global rates, global equity risk premium, global inflation protection, global credit and currency. The next step is a deeper dive into secondary risk factors embedded in each primary risk factor building block. Third step is slightly more complicated as we try to account for sophisticated beta and alpha risk factors. At an overall portfolio level, we set limits on our exposure to the “liquidity” risk factor.

Q: How much domestic and how much foreign content do you have in the portfolio?

A: It’s still predominantly U.S. home-centric, which is something that we’re trying to address. Having said that, calculating exposure between domestic and foreign can be quite complex, for example the absolute return allocation is currently mapped to the U.S., which is not a true representation – you have to get to position-level detail from hedge funds for geographical  bifurcation. Furthermore, where a company is legally domiciled may have little relation to its origin of business.

Q: With the global risk factors, do you break them down geographically?

A: Yes, we include geography in our secondary risk factor analysis. It’s something we’re continuing to work on trying to increase that level of diversification. As a matter of fact, we have an upcoming work session on improving the diversification of the portfolio. Even though we set up the framework of looking at risk factors two years ago, and really adopted it a year and a half ago, it was designed to increase communication and highlight the fact that the portfolio was not diversified. Hence,  80% of the portfolio’s risk comes from one risk factor, equity risk, and two-thirds of the portfolio has a home bias allocation to the U.S.

Q: How do you create a risk budget and then manage it?

A: The risk budge starts by setting a high level risk factor allocation based on the plan’s risk tolerances.  This allocation becomes the risk benchmark. Then the active risk budget sets the boundaries to which we deviate in general from the risk benchmark. For example, we have three different zones: how far the CIO can deviate from the risk benchmark, how far the executive director and CIO can deviate from the benchmark, and lastly at what point any further deviation requires the board’s approval.

For active risk management we use both tracking error and relative VaR for limits. At the highest level, total tracking error relative to the risk benchmark is a green zone at 350 basis points — CIO operating range. From 350 to 500 basis points, the executive director and CIO can work together to have a greater deviation from the risk benchmark. Above 500 basis points, we have to get approval from the board.

Q; With dynamic asset allocation, how frequently are you shifting the allocation?

A: It can be quite frequent, as much as monthly. But we’ve outsourced that essentially to our absolute return fund managers and our external CIOs. So they are the ones who are basically making the dynamic asset allocation through our active risk budget.

Q: How did you restructure your communication process?

A: We adopted a comprehensive risk-based investment policy last May based on our green-zone investment concept. You can think of a green light, yellow light and red light, as a  communication tool that allows everyone to understand the boundaries in which we can operate. There are green/yellow/red zones for a multitude of risks, ranging from dollar allocations to tracking error. The investment policy clearly outlines who has accountability, authority and responsibility to manage within the risk framework concept.

Q; How frequently do you make presentations to the board?

We make presentations to the board on a quarterly basis. However they access to the daily  risk dashboard. Again it’s colour-coded. Whenever, a transition occurs into yellow or red zone the CFO notifies the appropriate parties, along with the CIO’s recommended course of action. Communication channels must be timely and fluid and not limited to quarterly meetings.

To learn more about the Global Investment Conference, please visit the events section of the website. If you are interested in attending the event, please email Garth Thomas to be considered, as limited space available.