Risk budgeting gets 2nd look from execs

When executives at Qwest Communications International Inc. talk about embarking on a new journey with the company's $9 billion pension fund, they seek to explore a realm of splitting market risk from active risk, of transportable alphas, overlays and growing complexity in investment management.

Their guide is risk budgeting.

"Risk budgeting is a journey, a process," said Kim Walker, president, Qwest Asset Management Co., Denver, which oversees a total of $13.6 billion in assets, including the defined benefit plan.

The results could bring increased efficiency to asset management, more control over risk, and returns better able to achieve the objective of funding pension liabilities, she said.

"We view risk budgeting as a tool in the investment process," said Ms. Walker. "We adopted it because of the limitations of existing tools. Risk budgeting is a robust tool.

"I'd say we are early on in the process" of using risk budgeting. "We've been seriously doing risk budgeting since last fall."

Kurt Winkelmann, managing director and co-head of global investment strategies, Goldman Sachs Asset Management, New York, which works with Qwest on risk budgeting, calls it a "process of making sure a portfolio's risk allocation is consistent with an investor's investment views."

"Asset allocation and risk budgeting are closely related," Mr. Winkelmann said. "Risk budgeting reframes discussion from portfolio weightings to risk allocation."

Risk budgeting is getting more attention from plan sponsors now for several reasons — the biggest one being the search for alpha.

"Because we've come through several years of poor equity returns, people aren't as confident today" about expected returns on traditional assets, said Charlie Jacklin, president, Mellon Capital Management Corp., San Francisco.

Also, he added, "more plans have funding issues because of the fall in bond yields," and many pension plans today are underfunded or marginally funded.

"People are asking, ‘Where else can we add value?'" Mr. Jacklin said. "They talk about absolute return strategies, long-short strategies, global tactical asset allocation and currency overlay strategies as a source of alpha."

A focus of risk budgeting is "trying to get expected return for plans up without raising expected risk or increasing it modestly," Mr. Jacklin said.

"The trick to risk budgeting is correlation. Overlay strategies tend to have low correlation to beta (or traditional) strategies." For example, "putting on a global tactical asset allocation will increase risk, but not very much, because it has low correlation to other assets."

"Risk budgeting provides an ability to use more sophisticated strategies," Karyn L. Williams, vice president and principal, Wilshire Associates Inc., Santa Monica, Calif., concurred. "You can't use strategies like that unless you have tools to measure risk on a consistent basis.

"Risk budgeting puts sponsors in a position to relax a mandate because they have the tools to closely monitor a manager, which reduces risk."

But risk budgeting doesn't necessarily lead to more complex investing, she noted. "It may mean preventing a fund from moving to alternative investments when it doesn't have to because it may lead you to restructure the existing portfolio better" in traditional asset classes.

Sara Somerville, product marketing manager, BARRA Inc., Berkeley, Calif., said risk budgeting "complicates how we measure risk, forecast risk and how we do asset allocation."

Even rebalancing becomes more complex under risk budgeting, she said.

Ms. Somerville gave an example of a pension plan sponsor seeking to rebalance a fund to a 60/40 policy allocation. The plan could find that the "rebalancing isn't taking you back to a neutral position, because equities have become more explicitly risky in a more dynamic, or more volatile, risk level in today's markets.

Risk budgeting will help a sponsor achieve a better mix in rebalancing, she added.

Qwest's asset allocation is 55% publicly traded equities, 5% private equities, 25% fixed income and 15% real estate and alternatives such as opportunistic risk-and-return strategies. One-third of Qwest's U.S. equity allocation is passive.

New strategies Qwest is using risk budgeting to evaluate include moving to more active from passive management; portable alpha; and overlay strategies such as global tactical asset allocation.

Qwest, while it still hasn't completed the initial process, is using risk budgeting in ever broader steps, from the micro to the macro. The company is examining individual portfolio holdings, managers, asset classes, total fund assets and liabilities.

"The goal is managing the fund efficiently," Ms. Walker said.

Risk budgeting "will assist you in challenging your assumptions and provides a framework for analysis," added Kathy Lutito, Qwest Asset Management director of asset allocation and risk management.

"Risk budgeting isn't like mean/variance (optimization), where you can buy a program and plug in assumptions and get an answer out," Ms. Lutito added. "Risk budgeting provides a way to think about separating market risk from active risk," or alpha.

"We haven't changed our strategic policy at this point," Ms. Walker said. "We are using risk budgeting to evaluate new strategies and strategies we didn't know how to model."

One of these is global tactical asset allocation. "We didn't know how to model it with previous tools," she said "But we know the impact on the fund now because of risk budgeting."

Risk budgeting will enable us to decide how we should divide risk (and investments) between alpha and beta strategies." Ms. Walker said. "One of the scenarios we are looking at" is portable alpha, she added.

"Most risk is from strategic asset allocation rather than active management," she said. "Is that the way it should be? Maybe we should increase active risk. You can take some strategic allocation bets by using more active strategies." Then the question becomes: "Do I have confidence I can identify the source of active risk?"

Ms. Lutito said issues in using new strategies like portable alpha include the difficulty in replicating markets outside the U.S. equity market.

"You have to have a good passive alternative for every market risk," she said, and in markets other than U.S. equity — such as international equity or even U.S. fixed income — the replication isn't so easy.

"It becomes more difficult and expensive; fees are higher," she said. "You have to consider replication in the cost of alpha," which would be a deterrent in using such a strategy.

"I don't think (risk budgeting) is the latest fad," Ms. Walker said. "I think it's a progression of analytical tools investors are using," she said.

"I'd be surprised if risk budgeting didn't become ubiquitous" in use by plan sponsors, added Wilshire's Ms. Williams.