The Broadened Command of the Pension Officer

Institutional Investor Magazine Pension Conference

8th & 9th January 1981 Waldorf Astoria

The Great Beta Debate

Institutional Investor Magazine Pension Conference

9th January 1981 Waldorf Astoria

Beta is the correlation coefficient between to moving entities. To the degree that they move together the Beta approaches 1.00. Beta became the quantitative measure for what was called systematic risk or the risk of just being part of the system, e.g., stock market, economy, etc. Individual stocks and portfolio price movements are measured by regression analysis techniques over time to obtain the degree of correlation between their movements as measured by Beta.

When a portfolio of stocks is selected, its Beta approaches 1.00, i.e., it moves surprisingly like the stock market both up and down. If one wants to diversify systematic risk with respect to overall stock price movements, other asset categories have to be selected starting with cash or their equivalents which are risk free. If one takes risk in the market, then the return should reflect a compensation for taking various levels of risk.

The Capital Asset Pricing Model (CAPM) is the theoretical expression for moving from risk free cash or its equivalent into risky assets. How do you measure the amount of risk taken against the amount of return earned to be able to tell if one is earning a commensurate reward for the amount of risk taken? Quantitative techniques provided this ability to measure risk against return. However, questions were raised about the validity of Beta in this regard.

This quantitative technique provided the measure of the amount of systematic risk, i.e., Beta. From an evaluation point of view it is an excellent tool. The debate honed in on the problematic aspect of the predictive ability of such regression analysis: would the Beta of the future be like that of the past for portfolio construction and risk/return management?

The predictive capacity of such analysis using Beta regression techniques were dubbed "Barr's Bionic Betas." Ideally, one would like to be able to select stocks that would have a Beta greater than 1.00 when the stock market went up and a Beta less then 1.00 when the stock market went down thus outperforming on the upside and underperforming on the downside relative to the overall equity market movement as measured by an appropriate index.

It's essential to evaluate investment managers' activity carefully and closely. Since they make so much money, they will do everything to make it appear that they are doing the best job available. They will "window dress" at the end of a quarter reporting a portfolio that has all the favourites while eliminating the dogs. They will tout an excellent return without indicating the level of risk that was taken to achieve it. All an investment manager's activity has to be tracked closely to determine the quality of the management. Risk, i.e., volatility, must be understood to make certain that downside possibilities are not excessive when they occur.

Quantitative evaluation products provided the ability to understand risk and return for stocks, portfolios and the entire pension fund. Significant returns are nice, but the risk undertaken to achieve them must be understood to prevent surprises from downside movements. Investment managers resist such evaluations which explain what they are doing. They would rather have a situation where they tell the client whatever they want and have the client accept any explanation without critical review.

It's interesting that the below promo for the Institutional Investor Pension Conference highlights negative articles written by investment banking firms First Boston and Salomon Brothers. These were in those days firms with some outstanding people. However, I suspect that they would not like to have their management efforts carefully reviewed and seek a way to criticise quantitative techniques which reveal essential information about the investment management process.

The great problem with pension fund asset management and other institutional investing is that investment managers are measured as if they were in a horse race which is almost universal and is called exactly that: performance evaluation and review. This leads to the kinds of excessive risk taking and management abuses that create an overall risk in the markets which then turn into huge negative returns where the market is blamed.

The pension plan sponsor seeks to achieve the actuarial rate of return on a consistent basis over time. This requires careful management of all the risk and return elements associated with the pension fund's invested assets. It's not a horse race based upon speculation with winners and losers. It's an investment process based upon valuation and understanding of risk and return managed in such a way as to consistently achieve a return at an acceptable level of individual security, portfolio and overall total fund risk which is quantified based upon past, present and expected future activity.