Risk & Portfolio Construction: ‘It’s not overly quantitative’
Look at how SAUL’s financial reports represent its asset allocation and you quickly realise that it does not think about that allocation in terms of asset classes, but in terms of strategies designed to meet well-defined objectives related to its funding position. There is the common split between ‘risk-reducing’ assets (36%) and ‘return-seeking’ assets (64%), but it goes well beyond that. The former includes high-lease-to-value property with Gilts-plus long-term return target, for example. The latter includes a 23% allocation to a multi-strategy alternatives portfolio with a cash-plus return target and a sub-10% volatility target. The equities allocation includes a high-income UK section tasked with achieving a 30% yield premium over its index while maintaining capital growth in-line with inflation, and most of the rest is in absolute-return mandates with cash-plus targets.
The fund’s first risk-parity mandate – £80m (€95m) with First Quandrant, with another cash-plus benchmark – fits comfortably in that context. SAUL has recently embarked on an LDI strategy with its consultant, Redington, and Legal & General Investment Management, to protect against the interest-rate and inflation risks embedded in its liabilities, but has also designed its portfolio to take account of its sponsor’s low tolerance for a worsening funding position or unexpected calls for contributions.
“We are taking advantage of asset classes and asset-allocation strategies that will enable us to meet the required rate of return we need to improve our funding position and ensure that we can meet our pension promises,” says CEO Penny Green. “We look at the required rate of return implied by our liabilities and then construct a portfolio that is likely to give us that return – or exceed it, ideally – subject to certain volatility constraints. We were attracted to the risk-parity approach because our ideal asset class presents us with equity-like upside returns with controlled volatility.”
The other thing that SAUL’s way of categorising its asset allocation suggests is that it doesn’t really make relative-value decisions between asset classes – for much the same reason that it doesn’t really think in terms of ‘asset classes’ at all. Instead, it thinks largely in terms of roughly balanced allocations to a diverse range of strategies with much the same objective – a medium-term cash-plus or Gilts-plus return with low volatility.
Again, risk parity fits very comfortably in this context. Much of the criticism of the strategy rests upon the idea that it makes little sense to apply leverage to an asset class – interest rates – that already looks very expensive. The question is completely alien to the way SAUL goes about its business.
Which is not to say that the fund isn’t aware of the pitfalls associated with not optimising at all for expected returns.
“We are aware of where this kind of strategy can go wrong, because that is a key part of our due diligence,” says Green. “That’s why we have gone with a manager that is ready to take views about relative risks sitting across the markets. When we were going through this process we looked long and hard at various risk-parity managers and certainly we feel very comfortable that the risk-control mechanisms, stop-loss protections and other controls are designed to protect against the scenarios that critics of risk parity refer to. What we liked about First Quadrant was the fundamental economic analysis that went into the risk allocation process – it’s not a black box, it’s not overly quantitative.”
So, while SAUL’s whole portfolio is certainly not managed on a risk-parity basis, it does share quite a similar philosophy with this specific strategy. Moreover, asked if a belief in the efficacy of risk parity should lead to the application of risk parity across an entire investment programme, Green concedes that “it wouldn’t be illogical” and notes that there are practitioners who pitch the strategy in precisely that way.
“I certainly wouldn’t rule that out for the future – but at the same time I wouldn’t rule it in,” she says. “As we work further into the relationship with First Quadrant, and indeed with our adviser, Redington, we might expect to apply risk-parity thinking to the rest of the portfolio, but it’s very early days. But is risk parity the nirvana? I don’t feel comfortable with the idea that there can be one strategy or one manager that can solve all of our problems, and for that reason I think it’s unlikely that all of our assets would be allocated to risk parity.”
Furthermore, SAUL is currently happy with the mandates it has in place, which are doing what was expected – so why replace them? Having a risk-parity allocation as just one part of an allocation makes much more sense than it seems at first, in the context of SAUL’s broader programme: this is not about asset classes, but about a diverse portfolio of strategies, of which risk parity is simply one more.