A SMART Approach to Portfolio Management: A New Paradigm for Managing Risk

The year 2008 was a watershed year as dramatic market movements exposed the flaws in the theory and practice of pension fund management. Solvency declined dramatically, hedge funds did not deliver, rebalancing policies detracted value and liquidity dried up tainting the allure of "alternative" investments. Many institutional investors are addressing these issues by focusing on risk-based allocations, risk parity solutions, tail risk hedging or other revisions to the strategic asset allocation. However, the lessons from the crisis seemed to have been missed as static policies for dynamic markets are undoubtedly flawed and have to be changed with the support of appropriate liquid, transparent and low cost benchmarks; implicit bets need to be made explicit and managed; naïve performance measures have to be improved; and the CAPM needs to be revamped dramatically. But this process can only start with investors taking the time to understand how various market factors influence assets or managers and then develop a set of rules so that as the factors evolve over time, the optimal portfolio evolves simultaneously. SMART (Systematic Management of Assets using a Rules-based Technique) management of assets and liabilities leads to improved solvency and a lowering of ALM risks. SMART is about introducing good process - namely, only measured and monitored risks can be managed. This book presents a new design for portfolio management that can be applied to pension funds, endowments and even sovereign wealth funds to allow CIOs to be smart about managing assets relative to liabilities and, at the same time, allows them to access alpha flexibly (and compensate managers only when they demonstrate skill), thereby improving solvency.