Has Risk Parity Jumped the Shark? | Chief Investment Officer

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In the American camp/classic television show Happy Days, the height of cool was The Fonz. With his leather jacket and mop of dark hair, The Fonz (always capitalized, even when spoken) epitomized what men of a certain age wanted to be: edgy, funny, desired, and a lovable rogue through-and-through. The Fonz was all these things, that is, until he took to the water and jumped a shark—literally, at least for television—with the aid of water skis, a powerboat, and a very bad script. All of a sudden, The Fonz wasn’t that cool anymore. The show’s popularity quickly declined. Thus the phrase “jumping the shark” was born: a good thing gone overboard, an idea whose time has passed.

In March, aiCIO asked whether risk parity jumped the shark. It was a question that three years ago would have seemed absurd. At that point, panel discussions on the topic had to start with a basic definition of risk parity; answers on aiCIO‘s inaugural Risk Parity Investment Survey suggested more confusion than cohesive thinking.

Not anymore. While there is still much debate over what constitutes “true” risk parity (passive or active? product or strategy?), there is no longer the need to define its basic meaning. Instead, at least according to the amount of mail received in response to our question, the debate du jour is whether risk parity has been too successful and has, like The Fonz, passed its prime.

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Responses have ranged from the negative (“this strategy makes too much intuitive sense to be a fad”) to the affirmative (“it certainly has jumped the shark because why would you buy levered bonds now?”) to the aggressive (“one risk parity vendor is acting like an intellectual bully”). Perhaps the most interesting argument, however, was that the nascent trend of risk parity’s inclusion in defined contribution (DC) plans mimicked the sadly common trend of “less sophisticated” investors being sold something right before a crash. “Isn’t this just like every other financial instrument that then blew up?” one respondent asked. So we went looking to see if this analogy held true.

We ended up in Denver, Colorado. Denver, it turned out, is home to one of the first DC plans to use risk parity (although as part of a target-date fund, and not as a stand-alone option). CenturyLink Investment Management, which runs the defined benefit plan for communications giant CenturyLink, also has a hand in choosing the company’s DC investment options. “We began investing in the Bridgewater Risk Parity (All Weather) DC fund in December 2011,” said CIO Kathy Lutito. “Risk parity is really a portfolio construction strategy. It aims to have solid returns with low volatility, which is definitely aligned with the same objectives of a good DC plan. Think about that in a target date fund framework: as workers get closer to retirement, that’s exactly what they want.”

Clearly, neither Lutito nor her investment committee are concerned that the construct has jumped the shark—although she admitted that she didn’t understand the reference right away. “We’ve had risk parity in our defined benefit plan for a long time,” she said. “When we suggested it for the DC plan, we already had a well-educated investment committee on the subject, so we didn’t get much pushback.”

If asset gathering success is a sign that a shark has yet to be jumped, then the success of Bridgewater, and of other asset managers guiding risk parity into DC plans, seems to belie The Fonz comparison. Risk parity is more popular than ever. According to sources, the DC-focused cousin of Bridgewater’s All Weather fund had $480 million in the DC assets at the end of January, with three clients. They expect to have more than $1 billion by the end of the summer.

Bridgewater, of course, had nothing but praise for Lutito and her pioneering commitment. “We’ve worked with CenturyLink going back to their US West days in the early 1990s,” said Bob Prince, co-CIO at Bridgewater. “Over that time they’ve been first-movers into innovative strategies such as inflation-indexed bonds (three years before the US issued TIPS), separating alpha and beta, and adopting the All Weather principles eight years ago. Adding a risk parity allocation to their target date funds is just the latest chapter in what has been a great 20-year partnership, and one of constant innovation by Kathy and her team.”

Whatever this DC-in-risk-parity growth suggests, one respondent summarized the shark-jumping quandary best. “It probably hasn’t jumped the shark, and we probably aren’t in a bubble, but risk parity will likely hit the same wall as every other popular asset class,” he wrote. “With so many assets flowing in, much risk parity will likely see subpar returns compared to the earlier years.” A recent signal out of Westport, Connecticut supports this claim: Bridgewater’s All Weather strategy will soon be closed to new investors, with new allocators being moved into a risk parity-lite fund. “There are only so many Bulgarian bonds, or whatever, that you can invest in,” one investor commented, referring to the passive approach (through which many bonds are bought) used by the firm.

If it’s true that risk parity’s future holds subpar returns, The Fonz analogy will have to be tweaked. It’s not that risk parity jumped the shark. It’s that investors might be swimming with them.

(April 26, 2013) – Buyouts are gaining in popularity thanks to the huge cost of legacy defined benefit pension plans burdening many companies across the US.

A report from Greenwich Associates found 17 major companies took pre-emptive action in offering notable lump-sum payouts in 2012 to current and/or former employees in an attempt to shed liabilities and help minimise the impact of volatility.

“Companies such as Lockheed Martin, J.C. Penney and NCR launched their lump-sum programs after Ford and GM kicked off the buyout blitz in the first half of the year,” the report said.

“Ford made its offer in April 2012 to 95,000 salaried retirees and former employees. GM followed with a similar offer to its employees in June, extending lump-sum options to salaried retirees unprotected by union contracts.”

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Lump-sum buyouts not only offer the opportunity to derisk and remove liabilities from balance sheets, but they can also help reduce funding gaps which are another major concern for many US corporations, said the report.

A recent study conducted by Greenwich showed corporate plan funding ratios fell from 89% in 2011 to 81% in 2012 on average, mainly driven by declining interest rates. More than 60% of US plans currently have funding ratios of 85% or less, according to Mercer Investment Consulting. These funding gaps represent the highest ever and are “projected to negatively affect the balance sheets and 2013 earnings of some corporations”.

However Ford and GM still remain in the minority with offers to current employees, as many companies limit their buyouts to former employees. Sean Brennan, consultant at Mercer, said: “By offering a lump sum to these bigger populations, companies are more likely to reduce the liability associate with them.”

Lump-sum buyouts do carry high administrative and execution costs. While much of those fees depends on the size of the membership and the funding status of the plan, Greenwich Associates consultant Goran Hagegard admitted the data suggested derisking via lump-sum payments remains “largely aspirational” for all but the best funded US corporate pension plans.

Derisking is picking up speed across the Atlantic too, but the size of deals has fallen in recent months. A new report from actuarial consultants LCP, to be published at the end of April, will show that 2012 saw a rise in derisking deals, but that they came with a drop in value.