Risk Parity: I’m a (cautious) believer
The principles of risk parity may be sound, the CEO of AIMCo tells Joel Kranc, but the exuberance must be tempered by the current economic climate
Alberta Investment Management Corporation (AIMCo) is not unlike many other traditional pension funds in Canada or North America in general. The C$70bn (€54bn) fund operates on an asset allocation model determined by the comfort level of its clients (a diverse group of 26 Alberta public sector funds). Approximately C$50bn (€38.5bn) is invested in equities, bonds and inflation-sensitive assets and the remaining C$20bn (€15.5bn) is invested in money markets and short-term bonds.
"The risk parity people would say - and I agree with them - that, ‘the scarce resource is not assets, the scarce resource is risk'," says Leo de Bever, AIMCo's chief executive officer and chief investment officer. "So you have to decide how much risk you can take and then you have to allocate that risk to where it is diversified in a way that gives you the highest expected return for the least amount of aggregated risk."
But despite his agreement with the risk parity model, in principle, de Bever has some reservations given the way in which bonds will likely perform over the next 10 years or so. "Since 1975, the return on bond risk has actually been higher than the return on stock risk," he adds. He notes that risk parity might not be as good a solution as it once was because the chances are that the expected return on bond risk over the next 10 years may be small or even negative.
"At this stage, I don't see [risk parity] as something I want to put a lot of emphasis on," he says. "But what I would like to do is get my clients ready for the eventuality, after interest rates have gone back to more reasonable levels, of implementing a strategy like [risk parity]."
At the moment the big obstacle, he notes, is an aversion to borrowing and leverage rather than concerns about the direction of interest rates.
De Bever says he is already laying some groundwork within the Government of Alberta by having discussions about risk parity models and the ways in which they can work for AIMCo.
"The reason I am having the discussions is because this strategy might be a way of making the funding of these plans less painful because you generate a higher return on [the same level of] risk," he explains. He says it is difficult, though, because the sponsor community does not want to be caught up in something it can be criticised for.
In terms of a timeline, de Bever says it could take a year or two to make it more palatable to the sponsor community. However, he has gone to the board to explain how it could work.
"From a risk allocation point of view it's absolutely the right thing to do, in some sense," he says. "But it's not just about risk allocation it's also about what you expect the rate of return on risk to be. Depending on the assumption you use, you get different answers."
In other words, if you think the bond market is a disaster waiting to happen, you would not advocate the model because the risk allocation may be more diversified but the expected return on that allocation could be disappointing.
"There is a search on for a magic bullet and risk parity is seen as the answer by trying to squeeze more return out of assets or risk," de Bever concludes. "While in principle I agree with that, we under-appreciate the risk in bonds. In Canada there was an 18% rate of return on index-linked bonds. But that 18% in 2011 almost guarantees it will be lousy going forward, because the real rate of interest on index-linked bonds in the US and Canada is close to zero."
He likens the clamour around risk parity in North America to the often-observed phenomenon of retail investors investing in what did well last year - instead of recognising that it might now be harder to overcome valuations precisely because of that previous performance.
On average, if real interest rates come back to 2%, from that point on one can make the assumption that the return on bond risk should be the same as the return on stock risk, says de Bever. "But in the current environment there is an asymmetric probability that the return on bond risk will be lower because rates have been so depressed and artificially manipulated."
But, he adds, in the long run he still believes in moving in the direction of allocating risk instead of assets and that is halfway to the risk parity model.
He has a caveat however about how pension funds in particular should think about implementing the strategy. "A pension plan should not do it in an asset-only space but should do it relative to the structure of its liabilities - which look like bonds," he advises. "Before you do anything you start with an underweight in bonds because your liabilities look like bonds. So you look at the net position, it's long equities, short bonds."
So, in a more normal interest rate environment, a pension fund might allocate even more in interest-rate sensitive assets like bonds than even a straightforward risk parity strategy, with its leveraged bond allocation, would suggest - because it would also be holding bond risk to immunise its liability-related risks. But in the short term, the downside risk associated with duration looks uninviting.
For the same reason, in the short term, de Bever says that AIMCo is attempting to "immunise" its liability-related risk by investing in things that are not quite bonds and not quite equities in the hopes that returns are not as correlated with the bond market or interest rates. He says that would include some types of infrastructure or financing of hard assets that are not as sensitive to movements in interest rates.
And so, he concludes, moving closer to having risk covered - which is what risk parity would cause one to do - is a good thing in the long-run. In the short term, one would be locking in a very low return on bond risk.