Risk parity is being hailed by some as an effective way of reducing risk without sacrificing returns, while others warn such promises are "an illusion". Chris Panteli finds out more
The concept of risk parity may have been little-known outside the US until now, but with its promise of low-risk growth, asset managers are betting it will gain traction within pension funds on an international scale.
After growing in popularity in the US, providers now feel the time is right to spread the concept across a wider market and a number of firms, including AllianceBernstein and Panagora, which has $700m of pension fund assets under management in its risk parity series, have plans to make inroads into Europe and Australia over the coming 12 months.
They claim their strategies can offer pension funds similar returns to a traditional 60/40 equity/bond portfolio but with far less risk, making it a natural fit for schemes looking to minimise their deficits. However, others warn there are hidden dangers lurking behind the promises.
Risk parity is a phrase first coined by Panagora CIO Edward Qian some five years ago. It has since been adopted as a general term for a number of investment techniques around since at least the 1980s which attempt to dampen volatility without reducing returns.
The logic behind the concept is relatively simple. A traditional 60/40 equity/bond benchmark may appear balanced from a capital allocation standpoint, but from a risk point of view equities contribute far more volatility. In fact, research by Panagora shows that from 1973 to 2009, equities would have accounted for more than 90% of the volatility of a 60/40 benchmark.
Equal volatility
The solution put forward by the risk parity approach is to reduce the equity weighting and ramp up the exposure to bonds through the use of leverage so both asset classes have a similar level of volatility.
In a portfolio of just stocks and bonds, this would result in a 28/72 benchmark, which would have resulted in returns of 8.8% from 1973 to 2009, compared with 9.4% for the 60/40 portfolio over the same period.
Crucially, although the investor would have earned a slightly lower return, the volatility risk would also have been much lower. While the 60/40 portfolio has a volatility of 9.3%, the 28/72 portfolio has a volatility of just 5.7%.
Qian explained: “The idea of risk parity is trying to allocate in terms of balancing risk between the more riskier assets and the lower risk or safer assets such as government bonds or high grade corporate bonds.
“When you do that you end up with a very good portfolio with very low risk. Investors or pension fund clients don’t live on the Sharpe ratio of return/risk; they live on returns. You have to add certain levels of risk to get that return, so we use the concept of balanced risk rather than increase your exposure to every asset class.
“Instead of for example going 25% equity and 75% bonds, it is better to go 40% equity and 150% bonds. That’s where the concept of leveraging comes in to reach the return/risk target.”
This promise of maintaining equity-like returns with a fraction of the risk has proven intriguing for a growing number of pension funds in the US, with both the California Public Employees’ Retirement System (CalPERS) and the State of Wisconsin Investment Board both hitting the headlines this year after considering the concept.
Wisconsin wanted to lower its equities and add a significant amount of leverage to its pension fund using derivative instruments such as swaps, futures or repurchase agreements. The idea of using derivatives was not well received in the state, however, and the board has put any such move on hold.
CalPERS meanwhile announced in February that it would carry out its own investigation into using leveraged fixed income.
“The risk diversification advantages of employing levered bonds in a portfolio with equities has prompted some pension funds to consider employing leveraged allocations to fixed income as part of their diversified portfolio strategy,” board members were told by staff.
The report is due to be delivered to the board in December, but staff have already expressed fears that the strategy could introduce interest rate risk to the fund, while the use of leverage could also enhance losses if fixed income assets post negative returns.
CalPERS are not the only ones to express concerns over the promises made by risk parity advocates. GMO head of asset allocation Ben Inker suggested the benefits of risk parity portfolios are “largely an illusion” and contain hidden risks such as confusing volatility with risk and including asset classes that have significant negative skew, which combined with leverage could be painful for investors.
In a paper published earlier this year, Inker said that by shifting to risk parity portfolios now, investors run the risk of loading up on fixed income duration following the best run ever by bonds, a run that has left government debt looking dangerously overpriced.
Inker goes on to highlight three basic weaknesses in risk parity portfolios. Firstly, they suffer from the same basic flaws as value-at-risk and other modern portfolio theory tools by confusing volatility with risk.
Secondly, some of the asset classes usually included in these portfolios – such as commodities futures - have risk premiums that may well be zero or negative for the foreseeable future.
And third, several of the asset classes involved in these portfolios have significant negative skew, which makes the backtests behind them suspect and, in conjunction with the leverage, could prove costly.
Inker also believes leverage is a dangerous tool for investors, warning that while it allows investors to magnify returns, it adds an element of path-dependency to them.
“An unlevered investor can generally wait for prices to converge toward economic reality, but a levered investor may not have that luxury,” he said. “A number of proponents of risk parity portfolios point out that stocks are inherently levered investment because the average company has a debt/equity ratio of approximately 1:1.
“What makes that sort of leverage acceptable while the other is not? To our minds, one very large difference between the two is that what the leverage companies acquire is long term and not marked to market.”
However, Panagora’s Qian said it is not the leverage itself that is dangerous, but rather how it is used.
“The leverage itself is not a bad thing. If you talk to a typical institutional investor and ask if they use leverage they will probably say no. But if you look more closely, they are likely to be investing in private equity, real estate and hedge funds. These alternative asset classes all use leverage indirectly, they just don’t show it on their books. Leverage is not a new concept that we are introducing here. It’s everywhere, it just depends how you use it.”
AllianceBernstein’s head of blend strategies Patrick Rudden agreed but adds legitimate concerns exist. “Anyone can very simply show that judicial use of leverage in this case actually results in something that is much less risky as a portfolio,” he said. “There are legitimate concerns about implementation relating to counterparties and having the appropriate agreements in place, however.”
Hard sell
It is perhaps this wariness over leverage that has so far prevented risk parity from taking off outside the US. Qian, who recently visited the UK and Europe to introduce the concept to investors, readily admitted it is not the easiest concept to sell to pension funds.
“We have been talking to a number of investors over here and this is a fairly profound change,” he said. “It will take some time and discussion for people to get their arms around the fact that we are basically saying that some of the assumptions you’ve made in creating your exposure to asset classes to gain risk premium exposure might be flawed.
“Conventional thinking isn’t necessarily the best solution and that takes a bit of work in getting across.”
AllianceBernstein is touting its own strategy, which is expected to launch next year, as a more dynamic approach to risk parity which goes some way in addressing some of Inker’s concerns.
Rudden said it would be naive to suggest simply levering bonds up will result in continued strong performance as part of that success has been from riding the tail wind from the secular decline in government bond yields.
However, he believes there is a case for a more dynamic approach, and one which would fit well with large funds in Europe.
“A lot of investors, including pension schemes, are rather addicted to an 8% expected return, and in the past they’ve got that expected return by leaning heavily on equities, Rudden said. “The problem with equities is they are volatile and you could say the rational answer is to de-risk and own less equities, but the problem is then you don’t get your 8% return.
“People are trying to have their cake and eat it too. They want the 8% return and are looking at using more diversification, a little bit of leverage and, in our implementation, something that is a bit thoughtful and dynamic around that to keep close to the targeted 8% return but doing so with less volatility and importantly less drawdown risk and negative skew.”
It is too early to tell how successful risk parity will be on this side of the Atlantic but there is clearly much for consultants and pension funds to think about. While the strategy could be regarded as a useful tool to help schemes reduce risk while seeking returns, it would be dangerous for any investment strategy to be seen as risk-free.
Perhaps the last word should be left to Inker, who reminded that as ever, past performance is no guarantee of future returns. “While investors need to take advantage of risk premiums if they are going to have any hope of meeting the targets they have set for themselves, those risk premiums can neither be assumed into existence nor counted on to continue because they were there in some historical backtest.”
