Sidebar to the cover story: How pension funds are defining their asset allocation as exposures or factors—and not buckets. Kip McDaniel reports.
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“We have a lot of equity risk in our portfolio,” Mike Mueller, the interim CIO of Oregon’s pension system, said from his Tigard-based office in May. He’s not alone: as the Global Financial Crisis revealed, most institutional investors were exposed to equities to a degree that they were unhappy with in hindsight. “In bull markets we do very well—just like many of our peers. But in down equity environments, our performance struggles.” As a result, Oregon and other large investors are altering the way they construct—and think about—their portfolios.
Let’s start with the thinking part. As seen with, among others, the Alaska Permanent Fund under ex-CIO Jeff Scott, large funds are trending toward the idea of defining their asset allocation as exposures or factors—and not buckets. “Not content with just one major innovation, in his two years on the job, Scott also has pushed for a new way of valuing risk and thinking about the fund’s portfolio,” aiCIO wrote in June 2011. “The idea is to focus less on the rigid categories of asset allocation, and look more deeply at the kinds of risk factors—corporate exposure, counterparty risk, currency fluctuations, inflation, and deflation—that so often cut across asset classes indiscriminately. Like Jesus said about the poor, unstable oil prices and variable investment results will always be with us. Yet, Scott hopes this new way of looking at risk might moderate the ups, and particularly the downs that roil the oil and stock markets.”
This idea has been partially mirrored by other funds—including the California State Teachers’ Retirement System (CalSTRS) under CIO Chris Ailman—and is gaining general acceptance, if not complete adherence. Ailman himself commented as such when talking to aiCIO in September 2011—and, echoing Mueller, spoke about the reason behind this shift in thinking on asset allocation models. “I’ve been quoted as saying diversification failed in 2008. It didn’t fail, but it didn’t work perfectly well either,” he said at the time. “In 2001/2002, and in 2008, all correlations pushed toward one, and diversification did not work as a risk reduction tool. So, as opposed to the short-term gains and losses seen in years like these, long-term results come from how you structure your portfolio, and your fund in general. It comes down to asset allocation.”
Perhaps the most significant—or at least noted—result of this ideological shift has been the increasing frequency with which the words “risk” and “parity” are mentioned in the same sentence within the confines of pension magazines and conferences. It’s logical: if asset allocation is no longer about investment instruments and all about investment exposures, diversifying those exposures and the risks each makes sense. And while the jury is still out on just how popular risk parity products—offered with increasing frequency by asset management firms clamoring to enter a market pioneered by some of the world’s most sophisticated hedge funds—there has been a clear trend toward thinking about portfolios within a risk-parity framework.
Of course, few will know of risk parity without also knowing of the controversy around it—namely that in its passive form, some investors have concerns that allocating to certain asset classes (commodities, perhaps) does not yield a risk premium. But this argument is a distraction, a forest-for-the-trees moment. What exposure-focused or risk-parity investing really entails is a search for a better diversification. What Mueller and Oregon are doing reflects this. “Last year, we formalized our ‘alternative portfolio,’” according to the longtime fund employee. “It’s a dedicated strategic allocation, a real return bucket for the fund—targeted for 5% of the overall portfolio—with the goal being reducing the reliance on equity risk.
With this new portfolio we are trying to diversify into opportunities such as infrastructure, natural resources, and hedge funds. We want to access royalty streams, agriculture, and timberland—things that are really uncorrelated. We are very selective—especially with the hedge fund component—as we are not trying to create a hedge fund portfolio for the sake of having one. Instead, he believes, the true goal of this whole conversation is to find “truly uncorrelated things. This is not as dramatic as risk parity. Risk parity entails the leveraging of lower-risk assets— something we aren’t comfortable doing at the asset class level right now. Over time, our approach should reduce the equity risks we face.”
Of course, even when thinking of risk exposures and factors—as opposed to traditional buckets—all is not perfect. As CalSTRS’ Ailman noted, “We thought [what Alaska and others were doing] was interesting and we headed down that path but, in the end, it surprised us: You can’t divide the portfolio up neatly into these little risk categories. It would be nice if life was that clean, but it spills over. So, we’re developing a risk overlay idea—that there are six key risk areas that affect the portfolio and what we’re going to do is find ways to measure that risk and develop strategies for when they get to extreme points. The idea is that we become a little more nimble in periods of market disruption. We think this can help us with our risk and returns in the future.”