Trustees, CIOs Question Assumptions Behind Risk Parity, Dynamic Asset Allocation

(October 12, 2011) — While dynamic asset allocation and risk parity strategies have gained ground among institutional investors as they aim to maximize their returns while avoiding risk and market volatility, some investors express concern and skepticism about the metrics behind such strategies.

Dynamic asset allocation and risk parity strategies are often based on incorrect assumptions, according to Damon Krytzer, a trustee at the San Jose Police and Fire Retirement Plan and managing director of Waverly Advisors, who notes 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 told aiCIO, 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 Krytzer, 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 recently sat with aiCIO 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.

Samuel Kunz, the chief investment officer of Chicago’s Policemen’s Annuity and Benefit Fund also perceives risk parity and dynamic asset allocation critically, and as a case-by-case decision. “Focusing on risk factors rather than asset classes is a trend that I expect to gather momentum in the coming years,” he told aiCIO. 

“Investors need to assess their ability to implement adequate risk management and performance attribution practices, which are a serious challenge with alternative investments,” Kunz wrote in a recent research paper on the topic.

Responding to Krytzer’s remarks, he said: “I would make a distinction between risk parity and dynamic allocation strategies, however, since all dynamic allocation strategies are not risk parity, and risk parity can be based on a set of systematic rebalancing rules.” He concluded in his research paper: “Ultimately, investors cannot have it all. There is more to risk than volatility, and volatility parity is not risk parity. Thinking about risk is a necessary step in the right direction because path dependency matters a great deal. But higher efficiency through extreme diversification also creates the need for leverage, and with leverage comes uncertainty. Efficiency makes a portfolio sharper, but portfolio returns pay the bills, and with leverage, the devil is still in the left tail.”

Of course, some in the industry are quicker to embrace the idea that such strategies as dynamic asset allocation and risk party produce significant value. According to new research published by Aviva Investors, UK pensions could have improved their long-term investment performance by up to 3.5% a year if trustees had applied dynamic asset allocation to their portfolios.