Risk Parity Losing to Risk Factors, Study Finds

Institutional investors are increasingly choosing smart beta and risk premia strategies as ways of incorporating risk factors into their portfolios over risk parity, according to S&P Dow Jones Indices.

While risk parity rose as an appealing diversification strategy post-financial crisis, investors said they faced challenges in implementing the strategy on a policy level.

Asset classes exhibited were “poor proxies for true risk factors such as growth and inflation,” the paper said, and certain investors said it was impractical to employ leverage to increase allocations to fixed income. A strong tilt towards bonds also presented undesirable duration risks and a potential for poor performance in a rising interest rate environment.

Instead, alternate—or smart—beta, the paper said, was fast becoming a preferable option for investors to potentially enhance returns or reduce risk.

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According to S&P, the blurring of alpha and beta “stems from the recognition that systematic risk factors historically have accounted for the majority of long-term portfolio returns and that a significant portion of the alpha delivered by active managers can be attributed to a handful of risk factors.”

Asset classes exhibited were “poor proxies for true risk factors such as growth and inflation.”

This inclination for smart beta was also evident in a 2014 State Street Global Advisors survey. It found 42% of 300 institutional investors surveyed expressed their commitment to allocate to the strategy. (However, an informal survey conducted by Chief Investment Officer found 75% of surveyed asset owners believed smart beta to be a passing fad.)

However, these strategies are not without their own implementation difficulties, the S&P paper said.

“The process of investing in alternate beta invariably starts by setting their investment objectives, selecting the target factors, selecting the index strategies and managers to carry out the implementation, and then constructing the portfolio as well as measuring and monitoring performance on an ongoing basis,” it said.

This is often a “strategic rather than a tactical decision,” S&P said, that requires a strong commitment from investment committees and the board of directors.

Long-short risk premia strategies have also become an appealing approach to risk factor investing, research found, in separating systematic risk factors from overall market risk and diversifying low-correlated risk factors.

However, the complexity of this low-cost alternative to absolute return strategies, could also present challenges such as high transaction costs, possible volatile and unstable correlations between factors, and extensive use of short-selling and leverage. Even with such issues, S&P said industry practitioners predict more interest in the strategy in the future.

Despite S&P’s findings of a decline in risk parity usage, CIO’s 2013 Risk Parity Investment Survey revealed a new dawn for such products in defined contribution (DC) plans.

According to the survey conducted from July to September last year, 15.2% of CIOs are using or would consider using risk parity as part of a custom target-date fund and almost 20% said they use or would use it as a standalone option in their DC plan.

BT’s £40 billion pension scheme has established its own wholly-owned insurance company in order to complete the UK’s biggest ever de-risking deal.

The trustees of the scheme set up the company—Guernsey-based BTPSI (No1) IC Limited—to insure £16 billion of liabilities against longevity risk, before then reinsuring through a longevity swap arrangement with the Prudential Insurance Company of America. The deal covers more than a quarter of the scheme’s liabilities.

The longevity insurance policy will provide income to members should they live longer than forecast, while the pension pays the premiums to Prudential Insurance Company.

A statement from the pension scheme said the establishment of its own insurer meant it could access the insurance and reinsurance markets directly and “achieve the best value” for the pension.

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Paul Spencer, chairman of the pension fund’s trustees, said: “This transaction has taken many months of hard work by the scheme’s executive team. This is a ground-breaking deal in terms of size, structure and with one of the leading life insurance companies in the US providing reinsurance.”

He added that the deal “significantly reduces risk and provides enhanced security for members”.

Martin Bird, senior partner and head of risk settlement at Aon Hewitt, which advised sponsor company BT on the deal, said insurance and reinsurance providers were responding quickly to the need for larger-scale de-risking options.

This year has already seen a number of de-risking deals struck for liabilities of more than £1 billion. Chemical company AkzoNobel insured its £3.6 billion ICI Pension Fund with Legal & General and Prudential of the UK in March—the UK’s biggest buyout of an entire pension fund—and this was followed by oil giant Total insuring £1.6 billion of liabilities with Pension Insurance Corporation last month, the second largest buy-in the UK has seen.