Texas Teachers bringing risk parity in-house

Officials at the $129 billion Teacher Retirement System of Texas, Austin, are gearing up to manage about $3.4 billion in a risk-parity approach in-house, making it one of the few pension funds to design and manage its own portfolio to even out risk across asset classes.

Texas Teachers follows the State of Wisconsin Investment Board, Madison, and the Healthcare of Ontario Pension Plan, Toronto, in managing risk-parity strategies internally.

Texas fund officials have been conducting something of a risk-parity experiment over the past two years: Bridgewater Associates LP and AQR Capital Management LLC were hired in October 2012 to manage an aggregate $584 million — just 0.5% of total plan assets in current dollars.

In July, Texas Teachers' investment management division began managing an even tinier portion of plan assets — 0.1% or $119 million — internally.

Returns of both the internally and externally managed risk-parity portfolios have been good, with the internal portfolio producing 11.8% for the year ended Sept. 30, 180 basis points over the 10% combined return of Bridgewater's and AQR's portfolios, according to a risk report presented to TRS trustees on Nov. 20 by Jase Auby, chief risk officer and senior managing director.

Texas Teachers' investment officers declined to talk about their experiment, but it was successful enough to persuade investment officers and trustees to change the pension fund's asset allocation to create a dedicated 5% allocation to risk-parity strategies.

Texas Teachers' staff will manage 50% of the $6.8 billion risk-parity portfolio internally with the balance split between AQR and Bridgewater.

The exact allocation to each manager has not been determined yet, said Howard J. Goldman, a TRS spokesman, in an e-mailed response to multiple requests for interviews and more information about the risk-parity strategy and other asset allocation and benchmarking changes.

As of Sept. 30, AQR managed $295 million in a risk-parity strategy and Bridgewater, $289 million, Mr. Goldman's e-mail stated.

Neither David G. Kabiller, founding principal at AQR, nor Parag Shah, a Bridgewater senior management associate, returned calls seeking more information about their firms' expanded risk-parity responsibilities for Texas TRS.

Before creating the dedicated risk-parity allocation, Texas Teachers' investment staff conducted an extensive asset review, led by Mohan Balachandran, senior managing director.

Mr. Balachandran declined to be interviewed as did other TRS investment staff, Mr. Goldman said in the e-mail.

But TRS' Sept. 18 and Nov. 20 meeting materials provide an in-depth look into the research behind the asset allocation that trustees approved at the September meeting.

The asset allocation study concluded TRS' current allocation likely would achieve the desired 8% long-term annualized return target over 20 years and that “no major changes seem necessary or appropriate at this time,” Mr. Balachandran told trustees during a webcast of the Sept. 18 board meeting.

But a 10-percentage-point shift of assets split evenly between the new risk-parity allocation and existing private markets portfolios (private equity and real assets) is projected to slightly increase volatility, modestly decrease liquidity and increase the probability of the pension fund achieving its 8% long-term target return, Mr. Balachandran's report to the board showed.

TRS' allocation reduces global equity to 57% from 61% and stable value to 16% from 18%; increases the real-return portfolio to 22% from 21%; and adds the 5% risk-parity allocation, board meeting materials showed.

Funding for the changes will come from the reductions in equity, bonds and directional hedge funds, the report said.

Mr. Balachandran's report projected the new asset allocation will increase volatility across the whole portfolio to 11.6% from 11.4%; use a “relatively passive strategy that relies exclusively on beta to generate real returns and risk-controlled leverage to achieve the target return”; and introduce leverage of about 4% of the total portfolio through the addition of risk-parity strategies.

As of Sept. 30, the portfolio weightings of TRS' internally managed risk-parity strategy were global nominal rates, 32.7%; global inflation-linked bonds, 29.5%; global equities, 25.9%; commodities, 7.9%; and spreads, 4%, according to Mr. Auby's Nov. 20 risk report.

Mr. Balachandran's September report showed the pension fund's risk-parity portfolio is slated to manage $1.5 billion by year-end 2014, $4.5 billion as of Dec. 31, 2015, and hit the target allocation — $6.8 billion — by the end of 2016.

The transition period allows TRS' investment division to set up its internal risk-parity portfolio management team “deliberately. We will take our time building this out. (Full funding of the risk-parity program) might go faster if all goes well,” Mr. Balachandran told trustees, the Sept. 18 webcast showed.

Texas TRS is joining a rarefied group of large asset owners that internally manage a significant portion of plan assets or overlays in risk-parity strategies.

The State of Wisconsin Investment Board, Madison, for example, allocates 6% of its overall risk exposure to risk-parity strategies within the $89.2 billion Core Trust Fund of the $96.4 billion Wisconsin Retirement System, said Vicki Hearing, the board's spokeswoman, in an interview.

SWIB's investment team manages two-thirds of the overlay internally, Ms. Hearing said. The remainder third is managed by AQR and Bridgewater.

By contrast, the C$60 billion (US$53 billion) Healthcare of Ontario Pension Plan, Toronto, “runs our entire fund this way, looking at contribution-of-risk factors, rather than asset allocation,” said James Keohane, HOOPP's president and CEO, in an interview.

About 95% of the Canadian pension fund is managed internally in a liability-hedge portfolio, including inflation-linked bonds, long government bonds, real estate and private equity. HOOPP investment managers run a risk-parity overlay on this portfolio, employing derivatives such as foreign-exchange forwards, equity and bond futures and a mixture of swaps and options to gain global equity market exposure. Leverage used in the overlay brings HOOPP's notional value to about C$120 billion, Mr. Keohane said.

The remaining 5% of the portfolio is in an internally managed hedge fund-of-funds portfolio.

The impact of applying a risk-parity approach across the entire pension fund has been positive, with a 10% annualized return for the 10 years ended Sept. 30, and a current funded status of 115%. HOOPP's target investment return is 6%.

But Mr. Keohane warned that it's “more difficult to use a risk-parity approach” using external money managers because “for it to be really effective, you have to run the overlay over the entire portfolio and you have to retain control.” n