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The Actuary The magazine of the Institute & Faculty of Actuaries

Risk Idol II: A call for contenders

P opular culture has set what seems to be an ir-
reversible trend of audience participation, and
actuarial conventions are no exception. Hence, at this year’s Younger Members Convention there was an exciting investment competition, ‘Risk Idol’. While the candidates may not have been subjected to the ridicule of Simon Cowell, they were confronted with an audience of over 60 young actuaries. The author believes the former would have proved less daunting!

Risk Idol finalists
The three shortlisted candidates came from the field of fund management, and were:
– Duncan Squire, Fidelity Investments
– Francis Cowell (no relation), Morley Fund Management
– Mark Hamilton, Alliance Bernstein
They each presented a paper on the subject of ‘Innovative risk management’. Choosing a winner was a difficult task, but the judges eventually settled on Mark Hamilton for his presentation ‘Beta management: A new tool for fixed-income investing’. For those who did not attend the convention, the underlying approach is summarised below.

Beta living through risk management
The fixed income manager’s toolkit consists of two instruments to improve the risk/reward payoff, namely alpha and beta. Alpha relates to the outperformance against a traditional benchmark index and will incorporate strategies such as tactical stock selection and asset allocation. Beta management encompasses identifying the long-term market premium for risk and adjusting the portfolio in light of current conditions relative to the long-term position.
The market risk premium for fixed income is not readily identifiable and can only be observed historically over a period of time. The upward-sloping nature of the major fixed income sectors suggests that a risk premium exists, as shown in figure 1. Adjusting for duration to create a level playing field increases the scatter effect (figure 2). Also adjusting the sector returns for changes in the slope and curvature of the government yield curve creates an almost straight line (figure 3).
With r2 of 99.5%, the relationship is almost linear. The slope of this line is 0.4 implying that the market risk premium has averaged 40 basis points for every 100 basis points of risk taken. This line is named the ‘fixed-income beta line’.

As easy as abk
If we consider the investor’s level of risk aversion, we can identify where they should be on the fixed-income beta line. The portfolio manager can then seek to generate alpha while managing the agreed beta level a simple strategy so long as the slope of the beta line remains constant. This is, of course, unlikely. The investor can vary the level of risk within their portfolio based upon the current slope. If the slope offers 20 basis points return for 100 basis points risk, the investor will reduce their risk exposure. A very steep slope will result in the converse: an investor will take on more risk.
Research indicates that there is an apparent correlation between the slope of the yield curve and the fixed income beta line. A steep yield curve equates to a steeper than average beta; a flat yield curve equates to a flatter than average beta. The yield curve can therefore act as a market signal. Grouping the calculations by the order of magnitude of the slope, namely steep, normal and flat, leads to dramatic results (figure 4).
The steep beta line offered 110 basis points of return per 100 points risk; the flat offered 40 per 100 while the flat beta line offered -5 basis points per 100 points risk.
The slope of beta lines was found to vary by country. The beta lines in the US and Canada have been reasonably steep over the period of investigation. This contrasts with the UK beta line, which has been flat, which is unsurprising given the historical flatness of the UK yield curve. The potential for relative value plays between the different regions naturally follows. For example, we could invest more in the US if the beta line is steeper than average and less in the UK if this is flatter than average.
In the near future, we could soon see portfolios that adopt a dynamic benchmark whose composition and duration would vary depending upon the shape of the yield curve. Nonetheless, the potential for beta management as a risk management tool of the future is compelling. Allocating risk, tracking-error budgeting, and benchmark selection are likely to be influenced by this exciting topic.

The next idol?
Who will challenge Alliance Bernstein this year? Competitors are asked to submit their entries about ‘Liability-driven investment’. In order to add some reality to the competition, the submissions can be based upon a sample pension scheme liability profile, details of which are available on request from elaine.delaney@gissings.co.uk. The submission should be no more than 3,000 words with unlimited supporting pretty pictures. The shortlisted three papers will be invited to present at the Younger Member’s Convention on 5 December 2005 in Cardiff.
Closing date for entries is 31 August 2005.