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Improvisation has a well-known technique known as “Yes, and.” The first player makes a statement and the second player begins their response with the words, “Yes, and.” It’s awkward, yes, but it also does its job: It teaches participants to be open to new ideas and opinions.
Here’s how we at aiCIO decided to try a little “yes, and” thinking of our own when looking at the topic of risk parity. Such an abundance has been written on the topic, and in an effort to have fun with it and get past all the hackneyed facts and figures, we decided to utilize the idea of crowdsourcing. We decided to follow leads generated by people outside our normal circles and utilize these sources to produce an article on the topic. The use of crowdsourcing reminded me of improvisation—we must go out on a limb sometimes to seek out fresh perspectives. After all, we can only cite Wake Forest University’s Jim Dunn so many times.
With a vague idea of the direction of the topic and the transience of a 140-character tweet, I typed a note highlighting my interest in the subject of risk parity. Who is using it? Why are they using it? Is it successful? I posted my interest on LinkedIn, and joined a “Risk Parity” LinkedIn group, which included a total of 95 attendees, consisting of consultants such as Hewitt EnnisKnupp and Maketa Investment Group, asset managers, and others in the industry solely focused on discussing the strategy.
Expressing my interest in risk parity within the social networking universe provided me with a wealth of material—whitepapers and a general buzz of both excitement and concern surrounding the investing pursuit, with the main point of worry centering on the price of bonds that preside in a risk parity approach. A few days after my LinkedIn posting, I received a call from Andy Spellar of the Clifton Group, a Minneapolis-based registered investment advisor, who told me that his colleague read the tweet and passed it onto him. He told me about his experience as the senior investment manager of the Fairfax County Employees Retirement System, one of the earliest adopters of a risk parity strategy. He told me the name of the fund’s current CIO, which led me on a 7:00 a.m. Amtrak train to Union Station in Washington, DC. Destination: 10680 Main Street, Suite 280, in Fairfax, Virginia. About a week after the tweet urging information about thoughts and usage of risk parity, I was sitting in the office of Larry Swartz, the current CIO of Fairfax County.
To the surprise of many, investment returns for the $3.2 billion fund rank second in BNY Mellon’s universe of public pensions in the United States during the 10 years ending March 31, 2012. “Yes, we’ve done well, but we don’t put out news releases or get a lot of press,” Swartz said, alluding to an obviously tight hold on managing expectations.
How has this little-known system been able to succeed over the long-term? “We started in 1999 moving away from a traditional portfolio, focusing more on risk as opposed to asset allocation,” Swartz told me from his sun-filled office. At the time, he said, there were no products using the risk parity term.
Swartz attributed some of the scheme’s success to the Board’s decision in the mid-1990s to not use a consultant, having the CIO focused on the plan 100% of the time instead of having the often part-time work of an external consultant.
There are some who lead, and others who follow. When it comes to risk parity, the leader in terms of a balanced-risk product was Bridgewater, said the CIO of the Fairfax County Employees Retirement System. (Others such as Boston-based Panagora would likely argue with this point.) “Our embrace of risk parity really started when we hired Bridgewater. We liked their All Weather product. If it made sense with 10% of our portfolio in 2003, we thought ‘why not do it with 100%?’” Swartz said.
The Fairfax County system has continued to focus increasingly on separating management of market risk (beta) from active risk, diversifying beta risk while its peers were still taking more traditional approaches—still wedded, in effect, to the 60% equities, 40% bonds mix. “We had more of a focus on separating beta and alpha at an early stage,” Swartz said.
For this Fairfax County scheme, that focus on separating beta from alpha at the portfolio level started by focusing on information ratios—calculating the return over the index divided by the tracking error of traditional long-only fund managers. To put it in a slightly different way, the system measured tracking error as an active risk by separating the volatility of the market and the manager’s tracking error to the market. “On the beta side, we increased diversification by having a balanced risk parity approach. On the alpha side, we concentrated on getting the best return for the additional level of volatility that active management includes,” said Swartz.
While the fund has not implemented the strategy to 100% of its portfolio largely due to the barriers of limited resources that are all too familiar in the public pension environment, the system has increasingly positioned its beta allocations to balance risk across growth and inflation environments in a manner similar to the underpinnings of Bridgewater’s All Weather concept.
This Virginia scheme found that by minimizing stock exposure and increasing bond exposure alongside greater leverage, the system was able to get a better return for risk-taking while minimizing drawdowns. The result: The scheme’s total beta exposure totals 133%, with 20% of capital going to active strategies, maintaining an expected volatility of about 10%. Skeptics of risk parity question the validity of, and see an inherent danger in, leverage—but from the beginning, leverage was not a dirty word for this pension. “I think leverage is one way you can use financial engineering to manage risk—it lets you use your capital most efficiently,” Swartz concluded.
“Public pensions are especially vulnerable now because of experiences over the last decade, but we’re very thankful to Bridgewater for helping put us in a safe position from the beginning,” said Swartz. He added that drawdowns, not volatility, were the real risks for asset owners, and that maintaining a risk-parity strategy over the long-term has enabled the fund to mitigate both of these portfolio threats. This Virginia scheme’s success comes from understanding a risk parity approach relatively earlier than its peers, Swartz believes. “But maybe I should be concerned that everyone is following a risk parity approach and now I need to do something else,” he said half-jokingly.
Swartz’ success as the CIO of this public fund also comes with its challenges, especially for one eager to embrace risk parity. “The difficulty is trying to attract and retain the small staff I need. The question of risk parity, or any complex approach, is whether it’s sustainable with the resources you’re able to maintain.” What are the lessons, then, that we can learn from the small Fairfax County scheme? Swartz laid out three key points:
• There are advantages with willing to be different—embracing risk parity at an early stage and deciding not to use a consultant, for example.
• There are advantages of focusing on allocation of risk and the most efficient use of capital.
• Be sure to understand where your manager is adding skill through stock selection, for example, and where they’re just giving you beta or simply riding market movements.
Since the Fairfax County Employees Retirement System made headway with a risk parity approach 14 years ago, fund managers have crowded the market with an array of risk parity products, or “solutions,” to take advantage of the growing demand for limiting volatility and portfolio drawdowns. Swartz said the system will continue to focus on the allocation of risk, because it has done well for the scheme so far.
Perhaps #risk-parity is not the coolest Twitter hashtag out there. I will go out on a limb and say that it will never rank in Twitter’s list of “trending topics”, alongside #jubileeconcert and #katyperry. It is, however, a valuable strategy that is clearly gaining attention in the investing world.
So the next time you’re on Twitter, try it: #risk-parity. Who knows where it will lead you.