Risk parity strategies making inroads in DC
Risk parity investing has gained traction among pension funds’ in-house investment teams globally in recent years with some of the largest schemes, such as ATP in Denmark and the Teacher Retirement System of Texas in the US, adopting the strategy.
Proponents of risk parity strategies say the focus on the allocation of risk, or volatility, rather than on the allocation of capital makes their portfolios more resistant to market downturns than traditional ones. And they believe the strategies are suitable for defined contribution (DC) pensions provision.
But will this relatively new concept be understood and accepted by ordinary pension scheme members and can hurdles such as
use of leverage and higher charges be overcome?
Torsten von Bartenwerffer, head of portfolio management and research in Aquila Capital’s quant team, says one of the benefits of risk parity is that it is simple to understand. “I’d argue that the concepts that underpin the 60/40 lifestyle concept approach, where 60% of a DC pension pot is allocated to shares and 40% to bonds at a certain point in a scheme member’s working life, are more complex, involving return forecasting,” he says.
Von Bartenwerfer acknowledges that in periods of rising equity markets, risk parity is likely to underperform, and also that the method uses leverage to amplify returns, which does not suit all investors.
And when all asset classes are under stress simultaneously, as happened in May and June 2013 during the ‘taper tantrum’, risk parity can result in losses. “The remedy is to identify those periods,” Von Bartenwerffer says. “That really is the only solution.”
UK DC pension schemes are limited in their choice of risk parity strategies because the strategy must fit their platform requirements, says Matt Roberts, senior investment consultant at Towers Watson. It would have to involve daily dealing and fit reasonably comfortably within the cost cap, he adds. This is pertinent because the UK government introduced a cost cap of 75 basis points on DC schemes’ default funds from April 2015.
“Some of the strategies aren’t implementable for DC schemes and some are, but more are becoming available over time,” Roberts says, adding that the 75bps ceiling on costs makes it more difficult for UK DC schemes to achieve genuine diversification in the default scheme. “Risk parity strategies do provide a better balance across the different risk premia, and are not so biased towards equities.”
A few DC pension schemes have adopted risk parity strategies as a core component of their default fund. “In general, the concept of risk parity makes sense, but it is not without its risks,” he says. “It’s not a no-brainer.” Roberts also believes that pension scheme trustees require training, especially in the use of leverage.
In a research paper on risk parity strategies published in October 2014, Towers Watson concluded that while thinking in risk terms was a useful concept in portfolio construction, investors have to consider many variables before taking on packaged risk parity funds. Risk parity is a different approach that might be suitable for some investors, but its merits do not mean that traditional approaches are flawed, according to the paper.
Schroders has introduced a volatility-cap approach in its new UK DC strategy designed to give pre-retirement options for investors after compulsory annuitisation ended in April. The cap incorporates ideas from risk parity into Schroders’ new multi-asset fund targeting returns of inflation plus 2%, with a maximum loss value of 8% over any given timeframe.
At a glance
• Risk parity is arguably a simpler concept than some DC pension approaches, but providers would need to get the ideas across to end-users.
• The use of leverage and high fees is seen as an obstacle to more widespread use of risk parity, with DC schemes in the UK particularly sensitive to fees.
• When risk parity is put within a target-date fund, there may be less need for education about the concept.
• The new generation is seen as less concerned about use of leverage.
In the US, AQR has introduced risk parity in certain target-date funds in its capacity as a sub-adviser. Robert Capone, managing director and head of DC and sub-advisory at AQR, says risk parity can be used in two ways in a DC scheme – either as a component in a sleeve, or as a standalone menu option in the plan where the scheme member actively chooses to use it. The latter method does not happen often, Capone says, because scheme members need to understand it fully in order to select it.
Putting risk parity as a sleeve or as a component in a target-date fund, on the other hand, may lessen the need for broader education, he adds.
However, while Capone believes that risk parity strategies can help create a more stable investment profile over a long investment cycle, he admits there is still some way to go before it is widely adopted in DC schemes.“I would be lying to you if I said there was a groundswell of acceptance,” he says. “There is a need to educate fiduciaries about the shortcomings of target-date funds — the home-biased investing, equity-risk concentration, a lack of truly diversified asset allocation, particularly risk diversification and a sensitivity to volatile periods.”
Von Bartenwerffer sees evidence among DC schemes of increased take-up of the risk parity approach. “Europe is still catching up with the US where uptake has been quicker and much more substantial.” He believes consultants will play a key role in educating both trustees and scheme members, which is crucial for increased use.
“Given how widely entrenched the existing approach for DC schemes to offer lifestyle or target-date funds as key or default options, it’s easy to understand why the uptake of a new approach can take time,” Von Bartenwerffer says. “Whether risk parity is embraced as a more central, default style option, or an add-in or alternate approach, only time will tell,” he adds.
Roberto Croce, director of quantitative research and the portfolio manager for the risk parity strategy at Salient Partners, believes the generation now at college will be less worried about the use of leverage in risk parity investments than previous generations.
“The arguments against using leverage don’t really apply in this situation because you have 85% free cash in the portfolio” he says. “Young people will find these concepts easier to adopt.”
Croce agrees that delivering the notion of risk parity to pension scheme members has been a big challenge. “In general, people aren’t interested in what the 54 instruments are that we use – they want to know what diversification is and what they can expect of the strategy.”
He admits that 2013 was a tough year for risk parity, but he points out that many investors were not surprised because they understood why it was happening. “Our point is we’re taking compensated risks, and mixing the set of risks we take in an intelligent way,” says Croce.
Salient has seen pension providers using risk parity in different ways in target-date funds, he says, with some adding a risk parity only to a proportion of the allocation and others running risk parity-only strategies where the amount of leverage starts high and is reduced through time to match declining risk targets.
In Croce’s opinion, this way of using risk parity — scaling the amount of leverage to target volatility — makes more sense if you buy into the concept of risk parity. But either is an improvement over the standard approach, he asserts