Institutional investors rushing to the “risk parity” party could find the leverage on tap a source of hangovers in years to come, says Ben Inker, a partner and director of asset allocation with Boston-based Grantham, Mayo van Otterloo & Co. LLC.
In a paper written last month, Mr. Inker cites both tactical and longer-term reasons investors ultimately might regret constructing a less volatile investment portfolio by cutting equity allocations and leveraging up bond holdings in order to equalize the risk contributions of both asset classes.
Among the potential problems cited by Mr. Inker, in an interview: The approach focuses too much on historic return patterns and co-variance matrices, at the cost of ignoring the valuations that exist today — in particular, the perilously high valuations of long-duration bonds. Over the longer haul, risk-parity strategies might prove vulnerable to overly optimistic projections for key asset classes, such as government bonds and commodities.
True to GMO's tradition of zigging when market sentiment is zagging, Mr. Inker's cautionary shot comes as a growing number of investment consultants and money managers are citing risk parity as a more efficient way to structure portfolios.
At least three big public pension funds appeared to accept that argument in the first quarter of 2010.
In late January, the board of the $67.8 billion State of Wisconsin Investment Board moved first, approving plans to employ leverage to eventually boost the portfolio's market exposure by 20%.
On Feb. 24, the $10.3 billion Ohio Police & Fire Pension Fund likewise approved a 20% leverage target — the balance of a 31.6 percentage-point boost in bond allocations, a 14.6-point cut in equities and a new 3-point allocation to commodities.
And on March 18, the board of the San Diego County Employees Retirement Association adopted a new asset allocation plan with a 35% leverage target, which roughly halves the $7.2 billion system's equity exposure, boosts its holdings of U.S. Treasuries and other fixed income and adds a 25% weighting in inflation-sensitive assets such as natural resources and Treasury inflation-protected securities.
As a tactical matter, Mr. Inker argues that moving now to cut back on equities — when both non-U.S. stocks and high-quality U.S. stocks continue to offer reasonable value — while loading up on “dangerously overpriced” government bonds suggests a greater focus on the rearview mirror than the road ahead.