Risk Parity: Missed opportunity?
Investment managers are launching risk parity funds in response to investor demand in the US market place. Matthew Roberts wonders why there hasn't been the same level of demand in the UK
Risk-based asset allocation is designed to provide a less volatile return stream over a full economic and market cycle through the building of a portfolio that is genuinely balanced across a range of different return premia or economic outcomes. If the objective is to achieve a return similar to that of equities, then applying leverage to lower risk assets (government and corporate bonds, for example) is required. While this sort of risk-parity based asset allocation is simply an extension of basic diversification theory, in practice risk parity strategies vary significantly. Different fund implementations can include very different betas or alternative betas, use different instruments and take different approaches to asset allocation and position sizing. This heterogeneity means that the merits of each risk parity fund need to be considered carefully and individually.
In general, there are many clear benefits associated with a strategy of this nature. A broader balance of risks should lead to less severe underperformance in equity bear markets and the overall volatility of a risk parity fund should be lower than that of a traditional 60/40 portfolio. In addition, risk parity funds are typically very liquid and financially efficient.
However there are moderate risks, which may have limited demand by investors for these funds to date. These include:
• The challenges associated with understanding a different way of approaching diversification.
• Susceptibility to periods where diversification isn't as effective - the events of 2008 were an example of this. Hence, it is important to understand the contingencies that are built into investment processes for periods such as this.
• Market timing risks associated with initial implementation. The drawdowns associated with risk parity strategies are expected to be less severe than with a traditional portfolio. Nevertheless, at a high level, moving from a traditional portfolio to a risk parity solution means selling equities and buying bonds and investors need to be comfortable with that transition and with making a reasonably significant asset allocation switch. While there is nothing intrinsically wrong with current low government bond yields, in terms of the outlook for a risk parity portfolio, it is worth highlighting that a sharp or unanticipated rise in nominal bond yields, led by real yields, may cause relative underperformance. This simply reflects that risk parity and traditional portfolios will experience drawdowns at different times.
• Curve fitting. Historical data will often be used for portfolio construction in a systematic way, so unforeseen market events could impact the portfolios.
• Meaningful use of leverage and derivatives, which can entail greater than average counterparty risk - although most risk parity funds leverage through futures with central clearing and margin requirements which helps to mitigate this risk.
• Basis risks. Whilst it is not likely to be material there can be basis risks associated with the use of derivatives. This is where the return from derivative investments diverges from that of the underlying physical securities.
Structural changes in the management of UK pension fund assets may also have played a part in limiting recent demand for risk parity funds. Many UK pension schemes pursue liability-driven investment solutions that require a LIBOR-based return stream. Risk parity funds may represent a sensible solution in this regard as we would expect them to provide a more stable return stream. However, some of the more sophisticated UK pension schemes have already moved towards more diversified overall portfolios with the objective of balancing risk premia across their entire portfolio of return-seeking assets. This might include less liquid assets that are not typically included in risk parity fund solutions.
Depending on beliefs, a bespoke return-seeking portfolio could comprise specialist managers across the full range of asset classes or a range of different beta solutions, potentially including ‘smart' or ‘alternative' betas, to achieve the desired balance. As a result, a ‘standard' risk parity fund solution may not be required for these investors.
Many defined contribution schemes are still at a relatively early stage in their life cycle and so a move to risk parity would represent a significant governance leap. As such, to date there has not been significant demand for these strategies from this UK investor group either.
We think a risk-balanced asset allocation approach is an attractive investment solution in theory and, when carefully applied, in practice. A fund solution may not be appropriate for some of the more sophisticated funds and may represent a governance leap too far for governance constrained clients. Nevertheless, we do expect that a number of UK pension schemes will find that they fit in neatly with their investment risk and return requirements.
Matthew Roberts is a senior investment consultant at Towers Watson