At Pension Bridge: What’s the Right Risk-Oriented Way to Allocate Assets?

A slowing economy? Rising interest rates? These and other economic factors make it hard to plan how to use risk parity in allocating assets.

Speaking at the Pension Bridge conference in San Francisco, Edwin Denson, managing director of asset and risk allocation at the State of Wisconsin Investment Board ($117 billion), examined the dilemmas of risk parity strategies, which measure risk when figuring out what to invest where.

“Reduction and exposure to risky assets just as they’re declining and haven’t recovered” is one of the potential drawbacks, he said. Another is a “rise in real interest rates,” he said. Sometimes things can easily go awry and a batch of new risks suddenly appear, he suggested.

Example: the 2013 “taper tantrum,” when fixed-income yields shot up as the Federal Reserve unexpectedly announced it would reduce its purchases of Treasury and mortgage bonds. The carnage from falling stock and bond prices, owing to the threatened reduction in Fed stimulus, prompted the central bank to back off that plan

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The amount of debt any portfolio carries can affect its returns, Denson said. That even can impact a manager’s ability to sell assets when needed, he added, saying, “liquidity risks can also arise at times when the strategy struggles, again, depending on the amount of leverage that’s employed.”

Another challenge is the lack of a proper benchmark for risk parity. This is due to the wide array of investments located in these types of portfolios, market volatility, and of course, the degree of leverage involved. The Wisconsin official said that, even if the investment community were to agree on a passive benchmark, equity volatility would be an issue.

“It’s hard to imagine there ever being a complete consensus on what volatilities of various asset classes should be in terms of the inputs into a risk parity strategy,” he said.

In a low-return environment, many allocators are wondering if the strategy makes sense, as its goal is more oriented to mitigating crises and downturns than to maintaining a portfolio in times of lackluster returns. While Denson said this is a challenge “in general,” and puts risk parity at a disadvantage, he said fixed-income and inflation-sensitive assets are more likely to suffer from this.

“Risk parity did outperform significantly during the financial crisis and continued to outperform through the European debt crisis,” he said. “However, the strategies have tended to underperform to some degree in the recovery since those two crises.”

Denson expects the same pattern to emerge “in any market crisis that is driven by declines in risky assets,” but does not see the next downturn to be as severe as the financial and European crises. “It’s going to affect all strategies and [is] not contingent on risk parity in any particular way or relative fashion,” he said.

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Tags: Edwin Denson, Pension, Pension Bridge, Risk Parity, State of Wisconsin Investment Board

Investment officials at the California Public Employees’ Retirement System (CalPERS) are developing a formal policy in support of carbon pricing, with the aim of making large greenhouse gas emitters pay a price for their emissions.

While officials of the largest US pension system, with $354.4 billion in assets under management, have long supported carbon pricing, they have never had a formal policy on the issue. Such a policy would help shape CalPERS’s engagement with the energy companies in its portfolio in particular, as it attempts to negotiate with them on reducing their carbon emissions.

A draft policy presented to the system’s investment committee at its March 19 meeting says CalPERS wants a “clear carbon pricing framework that approximately prices the externalized cost to the economy and society from greenhouse gas emissions.”

Generally, there are two carbon pricing schemes in place in parts of the world: taxing companies with large greenhouse gas emissions or a cap-and-trade system, which requires companies that are big carbon producers to buy permits from companies with smaller emission profiles.

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Under that scenario, the number of permits are limited, and they decline in number as years go on, meaning the bill continues to rise for companies with heavy emissions.

Beth Richtman, CalPERS’s managing investor director of sustainable investments, didn’t specify what approach she favored at the March 19 meeting, although she did say that specific prices should be set on carbon emissions by companies.

“An effective carbon pricing framework should decrease emissions and therefore the physical risk to investors’ portfolios from climate change,” she said.

Richtman told the investment committee that she and her team will be coming back with a formal policy on carbon pricing for their consideration at a later date but didn’t specify exactly when that would occur.

She told the investment committee that carbon pricing is necessary for the world to live up to the 2015 worldwide Paris climate change agreement to keep the rise in global temperatures to well under 2 degrees Celsius.

“This would shield our portfolio from the worst [effects] of climate change,” she said of a carbon pricing plan.

CalPERS has a large global equity portfolio of more than $170 billion, so its efforts on carbon pricing are aimed globally. CalPERS’s home state of California is one of the few in the US that have adopted some type of carbon-pricing system.

A cap-and-trade system law was passed in 2011, requiring large carbon emitters to buy permits that allow them to continue to produce large amounts of carbon. The alternative to buying the permits was for companies to voluntarily make emissions cuts. Carbon emissions have gone down since the law went into effect in California, but the state has also put into place broad-based rules requiring, for example, utilities to significantly increase the amount of renewable energy they use to generate power. By 2030, utilities in California must get 50% of the power to generate electricity from renewable power sources. So, it’s unclear what effects in terms of carbon reductions can specifically be attributed to carbon pricing.

The United States as a whole has no carbon pricing rules and attempts by Democratic lawmakers to get a bill through Congress on the issue have gone nowhere in what had been the Republican-dominated Congress. Approximately 40 countries have some type of carbon-pricing systems.

Just two weeks ago, Canadian Prime Minister Justin Trudeau put a carbon tax on the governments of Ontario, Manitoba, Saskatchewan, and New Brunswick for failing to come up with a plan to reduce carbon emissions. All provinces in Canada were required to submit a plan as most of Canada embraces carbon pricing.

Tags: Beth Richtman, CalPERS, Carbon Pricing, Fossil Fuels, Pension