Some large pension funds are grouping together risk premiums as the basic building blocks to diversify equity portfolios, substituting them for traditional methods based on such characteristics as geography and sectors.
While risk premiums have been exploited by money managers as part of the investment portfolio for years, some pension funds are pushing the idea a step further. By separating the risk premiums from market returns, these funds are taking the concept beyond individual investment portfolios and applying it at the broader asset allocation level, sources said. The strategies are often implemented on a largely passive basis in combination with some active management to capture certain risk premiums such as small-cap risk premium, low volatility and momentum.
“What we're doing is taking advantage of known phenomena in the market,” said John Johnson, chief investment officer of the $6.5 billion defined benefit plan of the Wyoming Retirement System, Cheyenne. “This is really parsing out beta in minutia compared to what we've done in the past.”
The Wyoming Retirement System was among the first U.S. public pension funds to implement a strategy that carves out a specific portion of its equity allocation to capture size, value and low-volatility risk premiums last year. The portfolio accounts for about a third of the $3.5 billion equity portfolio, with State Street Global Advisors managing the bulk of the strategy.
The C$3.8 billion ($3.7 billion) NAV Canada Pension Plan, Ottawa, is now considering a similar move, said Paul Fahey, vice president of pension investments. The fund is in preliminary discussions to implement an equity strategy combining three risk premiums — risk-weighted, value and quality.
Separately, the 200 billion Danish kroner ($36 billion) PKA, Hellerup, Denmark, has completely abandoned the traditional ways of allocating equity investments to restructure its entire equity portfolio based purely on 17 risk premiums. PKA implemented the strategy in 2012.
“We wanted a portfolio with much less tail risk, and one that's more robust both when markets are doing well and when they're doing badly,” said Claus Joergensen, head of equities at PKA, which is owned by five Danish occupational pension funds and oversees their allocations and investments. “In a sense, it's more important that the portfolio is well positioned during market downturns, when correlation among asset classes reverts to 1.”