Report Explores Embedded Risk Within Strategic Asset Allocations, Champions Dynamic Approach

(December 15, 2011) — A new report is championing the value of a dynamic beta strategy in portfolios to better manage risks.  

The paper claims that a well-designed dynamic beta program can lower the overall risk of a fund — where risk includes volatility of returns — while earning a positive return.

The report — by Timothy B. Barrett, the chief investment officer at Eastman Kodak, Donald Pierce and James Perry of the San Bernardino County Employees Retirement Association (SBCERA), and Arun Muralidhar of AlphaEngine Global Investment Solutions — asserts: “A dynamic beta program implemented through an overlay and customized to each investor’s needs can help manage portfolio risk from an asset-only perspective or an asset-liability perspective. The introduction of dynamic beta provides substantial improvements for traditional investment portfolios as well as portfolios with risk-parity approaches and allocations to alternatives…The simple dynamic beta program alters outcomes by managing the tails. Traditional tail risk hedges involve buying expensive out-of-the-money options. But tail risk management can be achieved less expensively through the dynamic beta program.”

The main thrust of the paper is that most strategic asset allocations confuse strategic asset allocation with static asset allocation, resulting in embedded risk. “In short,” the paper concludes, “investors that engage in the development, implementation, and execution of dynamic beta programs can get paid to manage risk.” The paper demonstrates how San Bernardino County Employees Retirement Association successfully employed such a program since 2006 within the context of their rebalancing program and focuses on the importance of governance, clear assignment of responsibility, provision of sufficient resources to staff to engage in these activities and effective monitoring in generating such results.

According to Muralidhar, all other strategies, whether buying put options on equity, buying tail-risk hedges, or selling equity to buy long-duration fixed income, are unwise strategies as you pay hefty fees to de-risk. “You pay the manager/broker who provides this product and you pay with guaranteed higher contributions in the future,” he said. 

Consulting firm Wilshire Associates has echoed many of the findings by Barrett, Pierce, Perry, and Muralidhar, recently releasing its own report on dynamic asset allocation, referencing the strategy as a “game plan for systematic de-risking of corporate defined benefit plans.”

Wilshire’s report says: “Defined Benefit plans, along with all other investors, have suffered through two of the worst bear markets in our country’s history, with barely five years between them…Dynamic asset allocation is a strategy for reducing the volatility of an investment portfolio as its relationship to promised liabilities improves. A dynamic plan also helps decision makers consider and balance the link between reduced risk and expected costs. Despite the rather straight-forward approach to the strategy outlined above, managing a dynamic asset allocation is far from easy and, as the name suggests, economic and investment conditions are ever changing so that implementing the plan is a fluid process.”