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Leveraging the Investment Decision Process: Dynamically Managing Beta and Alpha Dr. Arun S. Muralidhar Chairman M cube Investment Technologies, LLC 22.

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Presentation on theme: "Leveraging the Investment Decision Process: Dynamically Managing Beta and Alpha Dr. Arun S. Muralidhar Chairman M cube Investment Technologies, LLC 22."— Presentation transcript:

1 Leveraging the Investment Decision Process: Dynamically Managing Beta and Alpha Dr. Arun S. Muralidhar Chairman M cube Investment Technologies, LLC 22 July 2005

2 2 Roadmap: From Static to Dynamic Portfolios Traditional approach – Alpha from external managers New approach – Add alpha from informed decisions Transparency and governance are critical Dynamic Alpha Management Dynamic Beta Management Consider Simple Rebalancing Strategies Hire Managers on a Static Basis (incl. Currency) Set Static Strategic Asset Allocation Using ALM

3 3 Clients Investment Philosophy Asset allocation: key source of return Ranges will be maintained through a disciplined rebalancing program Diversification by and within asset class is the primary risk control element Passive alternatives to actively managed portfolios are preferred, especially in highly efficient markets

4 4 Key Conclusions Separating alpha from beta - Too much focus on alpha, not on beta Little focus on impact versus liabilities Dynamic alpha and beta management may be more valuable than static alpha All portfolio decisions (incl. rebalancing) impact returns and risks; Must make decisions in an informed manner

5 5 Investment Decision Process (IDP): Many Embedded Decisions Total Portfolio/Liabilities LC SC ACWI EMG SC Equity 64% Cash 0% Alternatives 13% Fixed Income 23% Non US 24% Domestic 40% Core 21% HY 1.5% Emerging 0.5% PE 4% RE 9% Benchmark Misfit Risk Asset Allocation Decision Manager Selection and Allocation Important to manage/monitor each decision and understand individual and aggregate contribution to risk/return

6 6 Passive: Calendar or range-based rebalancing Dutch model: benchmark includes drift until range is met or calendar period is completed When range hit, go either to range or target or in-between (what happens within range???) +/- 3% range for most assets; 4% for RE Client policy gives discretion = Tracking Error The Old Static Framework for Beta

7 7 Single asset class focus: Optimize information ratio on active managers for a risk budget M 3 measure shows why this is incorrect (for single and multi-manager portfolios) Modigliani 2 : Could hire a negative IR manager! Dynamic management of alpha: Cash flows make pension funds active – already make decisions on who to give money to and when! The Old Static Framework for Alpha

8 8 Also means asset class performance will go through cycles – this aspect is often ignored Intelligent staff cannot sit by as markets evolve Managers can have low correlation with others Manager cyclicality – why fund a manager who is starting to underperform? Role of cash flows in implementing DYNAMISM Understanding Diversification or Low Correlations

9 9 Passive Rebalancing: Can Be Risky* Buy and Hold: Let Portfolio Drift 0.16% annualized return; 1.09% tracking error Worst drawdown = -2.15% (multi-year period) +/-3% range for most assets; 4% for RE** Impact: 0.01% annualized return for 0.21% risk Worst drawdown: much lower at –0.43% *Rebalancing was evaluated from 01/99 – 04/05. Only tested at the highest portfolio benchmark level. Transactions costs (one way) = 15 bps for equity; 10 bps for fixed income; 0.5% for alternatives **Range-based rebalancing = if any asset drifts to the range limit, all assets are rebalanced to benchmark

10 10 Passive Rebalancing: Not Cost/Risk Neutral (Cost 15 bps/yr) Buy and Hold Ann Ret: 0.16% Drawdowns!! Rebalancing Ann Ret: 0.01% Source: AlphaEngine TM

11 11 Passive Rebalancing: Not Cost/Risk Neutral (Cost 15 bps/yr) Buy and Hold Ann Ret: 0.16% Rebalancing Ann Ret: 0.01% Source: AlphaEngine TM

12 12 Informed Decisions within Ranges – Dynamic Beta Management Portfolio rebalancing is an active decision Use cash flows to structure fund appropriately Investment decision process creates opportunity Large cap vs. Small cap (+/-2%) Core vs. HY vs. EMG (+/-2%) EAFE vs. EMG vs. Small (+/-2%) Can staff use discretion to create value? Key: Have a robust, transparent, consistent process

13 13 Improving the Quality of Decisions Test variety of rules to use for specific decisions Consistent evaluation and performance metrics Many resources can be tapped Internal staff – have ideas that are unused Research: many articles on when asset classes do well Leverage external managers/relationships – Verizon Transparency and process key for good governance Prudence is Process

14 14 Focused on a Few Beta Decisions Total Portfolio/Liabilities LC ACWI EMGSC Equity 64% Cash 0% Alternatives 13% Fixed Income 23% Foreign 24% Domestic 40% CoreHY Chose a few decisions to make the point Developed multiple rules to diversify the risk for each strategy Asset Allocation - Equity vs FI Foreign Equity - ACWI vs EMG Domestic Eq. - LC vs SC Fixed Income - Core vs HY Asset Allocation - Equity vs Cash

15 15 Description of Beta Management Rules Equity vs Fixed Income vs Cash Price of Oil; Slope of Yield Curve, Equity Momentum, Halloween Rule; Fed Model Annual Turnover was only 5% Equities (ACWI vs EMG; Large vs Small Cap) Liquidity, EMG spreads; VIX, Yield Curves, Credit Annual Turnover was only 5% Bonds (HY vs Governments) Eq performance and VIX; Yield Curve, Halloween Annual Turnover was only 4%

16 16 Informed Decisions/Managing Beta: Improved Risk/Return * Asset allocation level: Keep return relative to Buy and Hold; lower risk relative to Rebalancing Stay within passive rebalancing guidelines Add returns at every level of IDP – alpha compounds *All Decision regimes were evaluated from 01/99 – 04/05. Transactions costs were higher for sub-asset class level. Decision making frequency was monthly Excess Annualized Return Tracking Error Information Ratio Worst Drawdown Confidence in Skill Success Ratio Asset Allocation level0.16%0.19%0.81-0.21%98% 57% Domestic Equity Foreign Equity Fixed Income 0.08%0.19%0.43-0.35%85%55% 0.04%0.12%0.36-0.21%82%53% 0.04%0.07%0.57-0.18%92%56% Source: AlphaEngine TM

17 17 Comparing Impact on Entire Fund Excess Annualized Return Tracking Error Information Ratio Worst Drawdown Confidence in Skill Success Ratio Buy and Hold 0.16%1.09%0.14-2.19%69%51% Strict +/-3% Rebalancing 0.01% 0.21% 0.03-0.43%53%42% Informed Decisions 0.32%0.21%1.5-0.18%99%64% At total fund level, better return with lower risk Drawdown at total fund level is also lower Translates into meaningful $$s = $180 mn/yr! Source: AlphaEngine TM

18 18 Managing Beta = Alpha ($) + Risk Management = Good Governance Informed Decisions Ann Ret: 0.32% Drawdown is ½!! Rebalancing Ann Ret: 0.01% Source: AlphaEngine TM

19 19 Ideas for Alpha Management UK vs Euro ex-UK managers: favor mgr in market with a higher interest rate Added 0.37% annualized over a static mix Govt. bonds: favor the manager with greatest momentum over last 3 months Added 0.27% ann. over a static mix of 4 mgrs Convertible Arbitrage vs Fixed Income Arb Allocate to mgrs depending on VIX and OAS Added return over static with 12% turnover!

20 20 Dynamic Alpha and Beta Management can Lower A-L Risk Annualized Liability Return (Benchmark) = 8.2% Note: These results are indicative and were obtained from another fund using the informed decision approach ( 2001-2005) OptionAnn. Growth in Surplus Volatility of Surplus Prob. Funded Ratio < 105% at y/e Static SAA-0.72%6.64%34% + Managers-0.64%6.59%29% + Rebalancing-0.57%6.72%28% + Dynamic +0.29%7.00%21% + Dynamic +0.34%6.96%19%

21 21 Summary Many clients focus only on SAA, Rebalancing and Static Allocations to External Managers Using dynamism in portfolio can lead to additional returns and lower Surplus-at-Risk Dynamism: both managing beta and alpha Cheaper source of excess return at total fund level (than any other alpha option) Easy to adopt by leveraging external relationships

22 Appendix

23 23 Where Should a Fund Take Risk? 12 0 1 2 3 4 5 0246810 Tracking error Excess return Tracking error vs. excess returns (net of fees) US Equity Large Cap US Fixed Income High Yield Non-US Equity EAFE - Japan Lite Emg Mkt Equities Non-US Fixed Income US Equity Small Cap US Equity Mid Cap Non-US Fixed Income - Japan Lite Source: Muralidhar (2001), Innovations in Pension Fund Management Consistent with Client philosophy – WHO IS THE MUG? From 12/87 to 12/97

24 Contact Information Name: Dr. Arun S. Muralidhar Title: Chairman Company: M cube Investment Technologies, LLC Phone: 1-646-591-6991 E-mail: asmuralidhar@mcubeit.com Website address: www.mcubeit.com


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