Although many institutional investors have spent the better part of the past three years chasing alpha, their biggest concern in 2005 should be the risks presented by the broad markets.
Max Darnell, chief investment officer of First Quadrant LP, Pasadena, Calif., argues that most pure alpha portfolios contain some systematic risk — broad issue risks such as interest rate or credit risk — and that the returns in many absolute-return portfolios invariably have some beta, or correlation to a broad benchmark. First Quadrant specializes in global tactical asset allocation strategies.
Risk aversion has become the hot-button topic over the past year, and many economists predict the value of the U.S. dollar will continue to decline and the Federal Reserve Board will continue to hike the federal funds rate. Therefore, broad market concerns such as inflation, currency and interest rate risks are on the front burner at many pension plans.
"What we've seen in the past year is a heavy dependence by institutions on structural alpha (traditional active portfolios)," said Mr. Darnell. "Institutions often invest in a package of investments that they think are low risk — but what they are in fact doing is investing in a bundle of risks." Those include volatility risk, or the risk of a wide fluctuation in the price of a security due to a market event; credit risk, or the potential affect on the price of a security due to a change in the credit rating of the underlying company; and interest rate risk, or the potential affect on the price of a security due to a change in interest rates.