Pension funds take new tack in diversification

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.”

So far, strategic tilting of a portfolio towards a group of risk premiums has been applied mostly to equities. But the Wyoming Retirement System is researching ways that the approach can be applied to fixed-income portfolios, Mr. Johnson said. “The data is there,” he added. “We're now trying to employ (fixed-income) beta factors passively in the same way that we've done in equities. It's an ongoing project, and we're hoping to have something next year.”

Portfolio diversification through the lens of risk premiums comes at a time when investors are reconsidering the ways they're investing in equities.

“There is a gradual but meaningful lifting of the gloom, but uncertainty continues to pervade markets,” said Andrew Kirton, global chief investment officer at Mercer, London. “Whilst investors are refocusing their growth portfolios to an extent, the risk remains that we could go back to more volatile conditions.”

As such, investors need to consider “the robustness of portfolios in the event of renewed market turbulence, even when considering increasing their exposure to stocks that could be expected to benefit from an improving environment,” Mr. Kirton said. Therefore, some are building in exposures to multiple return premiums while maintaining a degree of protection through quality stocks.

The appeal of risk management by way of beta factors rose after the 2008-2009 financial crisis, when traditional methods of diversification failed most investors, sources said. In the aftermath, strategies that capture the low-volatility premium gained credibility among institutions. However, as global markets have become more buoyant, performance of low-volatility strategies has been more subdued.

“It tends to be the case that minimum volatility does well in high-volatility periods, but (the strategies) don't do well all the time, just as value will perform well at certain times and not others,” said Brett Hammond, managing director and head of index applied research at MSCI Inc., New York. Over the long term, however, strategies based on risk premiums tended to outperform the parent market-cap-weighted indexes.

“We're still in the early days, but more and more organizations are adopting a family of risk premiums” with low correlation to each other as the basis for asset allocation, said Mr. Hammond, whose company is assisting about two dozen clients looking to combine several risk premiums as part of the portfolio diversification process.

Richard Lacaille, London-based executive vice president and global chief investment officer at SSgA, said the firm continues to see increased interest in strategies with risk premium tilts.

“Although 2012 was a positive year for stocks, the memories of the past sell-off continue to be something people are concerned with,” Mr. Lacaille said in an e-mailed response to questions. “How and when to use alternative beta strategies, and how to combine them in portfolios are among the most common questions we are asked.”

One major concern is the potential that compensation might diminish for a particular risk premium as more investors chase after it, sources said. “Another is transaction costs,” Mr. Hammond of MSCI said. “The risk premium may exist, but accessing it may require you to trade so much that you don't get the benefit of the factor.”

Mr. Joergensen of PKA said the decision to restructure the equity portfolio began in 2011, when PKA chose three partners — AQR Capital Management LLC, J.P. Morgan Asset Management and Deutsche Bank — to “analyze the risk premia, the fundamentals behind these risk premia and which to include in the portfolio,” he added.

Back-dated tests conducted by PKA using 16 years of data revealed that an equity portfolio based on risk premiums exhibited lower volatility and a Sharpe ratio that doubled compared with a strategy based on traditional asset allocation. Furthermore, lower tail risk was evident during times of distress, such as during the 2008-'09 financial crisis and the aftermath of the 2000 technology bubble burst.

“The main objective is to lower the risk allocation to equity beta,” Mr. Joergensen said. “That freed up the risk budget for other parts of the portfolio.”

About 70% of the risk of PKA's equity portfolio is dedicated to traditional beta — including developed markets, low volatility, emerging markets, frontier markets and small-cap risk premiums. The remainder of the portfolio targets alternative beta, including dividends, implied volatility, merger arbitrage, value and liquidity event risk premiums. (PKA does not publicly reveal all 17 risk premiums per company policy.)

PKA's equity portfolio is largely managed passively, with some active strategies. For example, the pension fund hired Acadian Asset Management LLC to run a $450 million managed volatility strategy in January. In 2012, the first year of implementation, the public equity portfolio returned 19% with less volatility than the MSCI All Country World index, which returned about 17% in local currency during the same period.

Mr. Joergensen added: “The next step is to further optimize the portfolio.”