There is a debate as to whether changing the weight methodology of a market index is really active management or an alpha strategy, rather than a beta strategy or discipline.
My recommendation is that the objective decides what is beta and alpha. What is important is to have the objective defined by a rules-based index. If this reweighted index is the stated objective of an exchange-traded fund, mutual fund or client, then beta is the portfolio that matches the risk/reward of this objective index version. It also follows that alpha is the excess return vs. this modified index objective. All comparisons to the traditional generic market index are good information to know, but do not determine the alpha and beta calculations.
The “smartest beta” portfolio is the portfolio that best matches and achieves the true client objective with the least amount of risk and cost. Risk is best measured as the uncertainty of achieving the objective. Cost is the amount required to fund the objective.
The true objective of most institutions and even individuals is some type of liability (annuities, banks, insurance, lotteries, pensions, etc.). The absolute level of volatility of returns is not risk given a liability objective. Indeed a 10-year liability payment is best matched and funded (defeased) by a 10-year Treasury STRIPS which has a certain future value. A three-month T-bill would be very risky given this liability objective as it has 39 reinvestment moments of uncertainty. Although the 10-year Treasury STRIPS would be much more volatile in returns, such a return pattern would match the present value behavior of the 10-year liability and thus be low risk or even risk-free (defeasance).
Given a liability objective it is critical to create a custom liability index, or CLI, as the proper benchmark. It must be a custom index because liabilities are like snowflakes ... you will never find two alike. The CLI is a portfolio of liability payments weighted by the schedule of payments (term structure). Most institutional liabilities are calculated by actuaries who produce an actuarial projection of the liability payment schedule for each client. As such, the CLI is weighted by the actuarial projection in present value dollars. To calculate the present value of each liability payment you need to price liabilities based on a yield curve of discount rates. Depending on the type of liability there are accounting rules (FASB, GASB, IASB, PPA, etc.) that dictate the discount rate methodology.
Most, if not all, liabilities are priced as zero-coupon bonds because they produce a certain future value. Using U.S. corporate pension plans, as an example, they are regulated by ASC 715 (formerly FAS 158) for GAAP accounting purposes. These rules suggest pricing liabilities as if they were AA corporate zero-coupon bonds. Because such bonds are not available in the bond market, they have to be manufactured as hypothetical zero-coupon bonds. As a result, liabilities behave like a yield curve of zero-coupon bonds weighted by the actuarial projections. This means that pension liabilities are extremely interest rate sensitive.
The CLI should calculate all of the necessary statistics to maintain and monitor a liability beta portfolio: term structure weights; total present value; yield to maturity; duration; growth rate; and interest rate sensitivity. The CLI is also the proper benchmark to measure liability alpha. If equity assets outperform the Standard & Poor's 500 index but underperform the CLI growth rate, did you earn alpha? In the eyes of the client you lost to liability growth which will damage the funded ratio and credit rating, and increase contribution cost. Liability alpha is the excess return vs. the CLI return (growth rate) and not vs. a market index return. Based on Ryan ALM indexes, liability year-to-date returns through Nov. 30 should be between 12.7% (10-year duration) and 22.2% (15-year duration). Hard to believe any pension plan earned liability alpha in 2014.
The key point here is that the client objective is truly the focus and determinant of relative risk and reward (beta and alpha). The client objective is to fund liabilities in such a way that risk and cost are reduced and stable over a long horizon. Given a long average life (duration) based on the liability payment schedule, then the liability beta portfolio needs to match these term structure weights. An S&P 500 index fund or any generic market index fund could never represent the beta portfolio for a liability-driven objective. Cash or a money market fund is a very risky investment for most liability objectives that have long average lives (duration).
The most appropriate and smartest beta portfolio is the one that matches the liabilities cash flow as measured by the CLI. In essence, the smartest beta portfolio is a custom liability index fund. Such a portfolio should be the core portfolio for any liability objective. By matching the liability term structure, the uncertainty risk of matching liabilities is eliminated and interest rate sensitivity is neutralized. By matching the liability term structure with bonds that have higher yields and lower present values (price) than the discount rates used, you have reduced costs. Since the accounting rules use AA zero-coupon discount rates, then a liability beta portfolio of A and BBB will produce higher yields and lower costs. This should provide significant cost savings of 10% to 15%. This process is called cash-flow matching. Beware of duration-matching strategies (i.e. immunization), which do not match the liability cash flows but just the average duration. This is not an accurate or cost effective way to match liabilities.
Ronald J. Ryan is CEO of Palm Beach Gardens, Fla.-based Ryan ALM Inc., specializing in custom liability indexes and liability beta portfolios.
