Pension Trustee Cautions on the Measure of Risk Behind Risk Parity

Risk parity has grown in popularity within the institutional investor world, yet many practitioners are putting clients at risk, according to at least one pension trustee.

(December 8, 2011) — “To invest based on risk parity, you must have an accurate measure of risk.”

That is the advice championed by Damon Krytzer, a trustee at the San Jose Police and Fire Retirement Plan and managing director of Waverly Advisors.

“Investors in a market environment driven largely by binary risk-on/risk-off decisions rather than by measurable fundamentals are faced with a choice,” a newly released report by Krytzer asserts. “Those empowered with a dynamic decision-making process can invest more tactically, targeting multiple sources of alpha and perceived inefficiencies. The point here is to develop a risk budget and to size and diversify positions opportunistically within an otherwise strategic allocation. However most allocators (e.g., a pension CIO) do not have this flexibility and must develop a long-term methodology to meet their targeted goals. One alternative presented is that of Risk Parity; to develop a constant and equal weighting to asset classes based on risk rather than allocating based on notional dollars.”

According to Krytzer, weighting portfolios based on risk contribution is ideal compared to weighting portfolios based on dollars invested.

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The report continues: “As I review risk parity proposals, the first obvious point is to understand the meaning of risk itself. Are we referring to tail risk and shock events, standard deviation of returns, or to measured volatility? All require very different actions. Most fiduciaries are concerned with portfolio volatility, and here the choice of measurement criteria is key. First, we must decide whether to measure relative historical or implied volatility, or possibly a blend of the two. Either way, trust me – a professional can be absolutely correct on the direction of volatility, but extremely wrong on execution based on tenor or measurement. Simply put, defining the volatility of US equities as ‘low’ or that of ten-year rates as ‘high’ is both art and science combined.”

Krytzer expressed his ideas about misperceptions behind dynamic asset allocation and risk parity strategies with aiCIO in October. Dynamic asset allocation and risk parity strategies are often based on incorrect assumptions, according to Krytzer, who noted that while he likes the idea that funds are using risk contribution as the focus rather than return distribution, their investment strategies should be based on different metrics. “These strategies assume that the asset allocation mix doesn’t change over time — with the false assumption based on diversification among asset classes rather than risk factors,” he said, noting that focusing on risk factors as opposed to asset classes is a more appropriate emphasis.

He added: “The revised approach would be better because you’re basing decisionmaking on actual underlying drivers that move asset classes — as opposed to asset classes that may be more highly correlated in different markets.”

According to many in the industry, dynamic asset allocation and risk parity strategies have gained heightened attention because of the desperation among investors to achieve success in a difficult market environment. “Returns have been awful. People are scared, and markets aren’t reacting the way people would like. So, you turn to something that seems like a systematic way to manage a challenging market,” Krytzer said, highlighting his belief that these models have underlying problems in the way many of them are currently applied and executed.

Krytzer’s assertions questioning the assumptions behind investment strategies follow recent comments made by Mark Baumgartner, Director of Asset Allocation and Risk at the $11 billion Ford Foundation, who sat with aiCIO earlier this year to discuss the market environment, ‘true’ diversification, and the end-goal of Foundation investing. “You have to make sure you are diversifying with risk factors, not just asset classes,” he asserted. “All investments have fat tails, all markets are irrational at times. However, something that is not widely acknowledged: You can reduce the impact of fat tails with good portfolio construction and ‘true’ diversification,” he said.

The concept of risk parity has also encountered scrutiny in a research paper by Marlena Lee, vice president at Dimensional Fund Advisors, which claimed that over the last 81 years, risk parity portfolios have not produced higher Sharpe ratios than the traditional 60/40 balanced approach.

The report, titled “Eight Decades of Risk Parity,” asserts: “This paper uses over a century of returns from nineteen countries to conduct an out-of-sample test of whether risk parity delivers superior risk-return tradeoffs. The results show that previously documented risk parity benefits are sample specific. Over the last eighty-one years, risk parity portfolios do not have higher Sharpe ratios than 60/40 balanced portfolios.”

According to Marlena, while proponents of risk parity claim the investment strategy is an alternative approach to asset allocation that promises better risk adjusted returns than traditional 60/40 balanced portfolios, the “promise is deceptive.” The reason, according to the paper: “Out-of-sample results show that the touted benefits of risk parity only appear in the last thirty years during a period of falling inflation and interest rates. Because bonds did unexpectedly well over this period risk parity portfolios also benefit due to their heavy bond allocations. Unsurprisingly, risk parity does poorly from 1956 to 1980, a period of rising inflation. From 1930 to 1955, a period of volatile but non-trending inflation, risk parity yields Sharpe ratios that are similar to traditional 60/40 portfolios.”

Read aiCIO’s Risk Parity Investment Survey.

Survey: LDI Reaches Five-Year Peak

As a new poll by SEI shows that nearly two-thirds of poll respondents are currently utilizing a Liability-Driven Investing (LDI) strategy, the Pension Protection Fund (PPF) has recruited four LDI managers. 

(December 8, 2011) — Just as a newly released global poll by SEI shows that liability-driven investing (LDI) strategies have hit a five-year peak despite historically low rates, the Pension Protection Fund (PPF) has recruited four LDI managers.

SEI’s study finds that the number of pension plans adopting LDI strategies has increased significantly since last year. According to the poll, 63% of surveyed pension executives now employ an LDI investment approach – the highest outcome in the poll’s five year history and more than triple that of 2007.

Highlights of SEI’s findings include the following:

1) Almost half (46%) define LDI as “matching duration of assets to duration of liabilities,” the highest percentage selection ever.

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2) The top goal of LDI continues to be “controlling the volatility of funded status,” as has been the case consistently in prior years.

3) The primary benchmark of successful pension management has changed significantly over the last four years to “improved funded status” in 2011 from “absolute return of portfolio” in 2007.

“The ongoing funded status volatility of pensions has placed increased pressure on organizations to make investment decisions that match the assets to the plan’s liabilities,” says Jonathan Waite, Director, Investment Management Advice and Chief Actuary of SEI’s Institutional Group, in a statement. “The volatility has also created a significant need for active LDI and de-risking strategies that can regularly monitor market changes and key trigger points.”

The implications of the burgeoning interest in LDI are numerous, the PPF’s recruitment of four LDI managers being the latest example. The PPF, a lifeboat for UK pension schemes, added Blackrock Investment Management (UK) Limited; F&C Management Limited; Insight Investment Management (Global) Limited and Legal & General Assurance (Pensions Management) Limited to its new panel.

SEI’s poll also coincides with several previous studies — one being aiCIO‘s LDI survey, released in November. Another study during the month by Russell Investments found strong interest from its US institutional client base in LDI. That popularity has driven Russell’s Martin Jaugietis to be named to a newly created role: director and head of LDI solutions.

Russell reported that its US-based LDI fixed-income assets under management have grown to approximately 50% of the company’s total fixed income AUM in the US as of June 30.

Jaugietis noted that corporate plans have become increasingly sensitive to the volatility of funded status, creating a greater demand across Russell’s client base for both advice and solutions. Currently, the average Russell consulting client has 38% invested in liability-hedging fixed income, up from 27% in 2006. Jaugietis also noted that as more is invested in liability-hedging fixed income, it becomes increasingly important to have a closer liability-hedging portfolio which requires more sophisticated solutions than simple duration extension.

The spark driving the popularity of LDI within the corporate pension fund universe comes from heightened regulation that demands greater solvency and higher funding ratios, along with the general longing to allow sponsors to focus increasingly on their core business as opposed to being distracted by their pension—often a pestering side problem. In 2006, the Pension Protection Act (PPA), which came into effect in 2008, provided the first set of rules forcing American sponsors to systematically contribute to their pension to carry them to full funding. Between 2003 and 2007, the funded status of plans in the US ballooned from 77% to 96%—a remarkable increase at first glance. But according to a UBS research paper by Francois Pellerin, a heightened level of contributions made by plan sponsors largely fueled the increase—highlighting a prevalent misperception among sponsors that a pure increase in equities got them out of their rut. “In analyzing the liabilities of 500 publicly traded companies with the highest pension exposure, I found that on average, the pension plan was 46% of the size of the company,” Pellerin told aiCIO earlier this year, adding that “LDI has flourished to control volatility so that plan sponsors can worry about what they’re good at—whether its building cars, making widgets, or whatnot.”

Read aiCIO’s LDI Issue here.  

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