Pioneers taking different paths on risk factor-based investing

When it comes to implementing risk factor-based investing, no two early adopters are using the same approach.

What pension funds share is the need to generate returns to meet funding requirements in the face of an extended low-return environment, said sources.

Risk-factor investing is alluring: Moving 10% of a traditional asset allocation to such an approach would yield about 100 basis points of additional return per year and a 20% assignment would yield about 200 basis points with lower volatility, specialist risk consultant and investment outsourcer QMS Advisors, Lausanne, Switzerland, estimated in a paper on its website.

But how the first generation of risk factor-based investors has approached portfolio construction varies widely.

Pensionskassernes Administration A/S, Hellerup, Denmark, for example, began its risk-based investment program with a pilot project in 2010, restructured the entire equity portfolio along risk lines in 2012, and has since extended the approach to its commodities, currency and fixed-income portfolios, said Nils Ladefoged, senior portfolio manager. PKA manages 212 billion Danish kroner ($31 billion) for three Danish labor unions.

The $9.3 billion Missouri State Employees' Retirement System, Jefferson City, on the other hand, made the shift in 2012 from “a world where capital is allocated based on expected returns to one where capital is allocated on expected risk and economic balance,” said Rick Dahl, chief investment officer, in the fund's 2014 annual report.

MOSERS' shift, which was completed in 2014, converted 80% of the portfolio to a risk-based approach, exempting only the illiquid securities portfolio, which accounts for 20% of plan assets.

Nearly all risk-factor investors use external managers in some capacity, sources said, but the most common first step is to invest in a money manager's risk-premium strategy.

The $14.5 billion New Mexico Public Employees Retirement Association, Santa Fe, for one, recently allocated $400 million to AQR Capital Management LLC to run in a risk factor-based portable alpha strategy, replacing a portfolio managed by 15 hedge funds, said Jonathan Grabel, chief investment officer.

The $35 billion Arizona State Retirement System, Phoenix, uses risk factor-based exchange-traded funds from BlackRock Inc. to run a $400 million overlay on its equity portfolio, which has a policy target weighting of 58%. The system also relies on the Barra unit of MSCI Inc. to assist with risk-factor identification and Nomura Securities Co. Ltd. to advise on global macroeconomic conditions, said David Underwood, the system's assistant chief investment officer.

Regardless of differences in implementation, experienced risk-factor investors, like investment executives at PKA and the Missouri and Arizona retirement systems, tend to build their multidimensional portfolios by:

• selecting specific alternative risk premiums — essentially the underlying macro factors — to capitalize on or protect the fund, such as growth, illiquidity, inflation and tail risks;
• determining which style factors best express those risk premiums, often including value, carry, volatility, momentum and trend; and
• deciding what asset classes, like stocks, credit, fixed income and alternatives, and which money managers best capture the risk premiums and style factors.

PKA's internal investment division, for example, laid the foundation for its risk-based investment process about 15 years ago when staff first started trading interest-rate swaps internally, said Mr. Ladefoged.

Many risk-based strategies are quantitative and PKA hired its first such manager 14 years ago and built its equity portfolio using more quant managers. Staff also have extensive experience in what Mr. Ladefoged labeled LSD — leverage, short investments, external and internal use of derivatives — all “tools that are helpful to run a risk-factor portfolio.”

Restructuring the equity portfolio, which accounts for about 40% (including private equity) of the PKA's risk budget, involved three layers, said Mr. Ladefoged's colleague, Soren Grooss, portfolio manager.

The “basic” first layer aims to get “exposure to the traditional equity market risk premium at the cheapest price possible.” External passive managers now run part of the portfolio, but until a couple of years ago, staff ran the whole portfolio passively using total-return swaps, Mr. Grooss said.

The “alternative beta” second layer is where Mr. Grooss said PKA gets “exposure to the largest and most well-defined risk factors” — quality, value, momentum, carry, implied realized volatility and low volatility — as well as smaller exposures in merger-arbitrage and insurance-linked securities.

PKA staff do manage some of this portfolio internally, but rely on four external managers to run the bulk of the portfolio — Acadian Asset Management LLC, AQR, INTECH and Quantitative Management Associates LLC — because the strategy requires “more skill than we have internally and our managers do it for an attractive, reasonable cost,” Mr. Ladefoged added.

The “opportunistic” third layer is “where we put our advantages to work through trying to find risks that PKA, a very long-term investor, can hold that most other investors can't,” Mr. Grooss stressed.

Some of those opportunities now, for example, stem from regulation-related derisking by European banks. PKA is obtaining its exposure to these bank plays synthetically through derivatives, to get access to implied equity repo, variance and correlation.

Messrs. Ladefoged and Grooss declined to provide the return of the PKA portfolio. But Mr. Ladefoged said the “more robust equity portfolio” is designed to control drawdowns so that “the portfolio won't rally or fall as the equity market does.”

The issue of leverage is critical to the success of Missouri State Employees' risk factor-based portfolio, Mr. Dahl, who declined to be interviewed, said in the annual report.

MOSERS' assumptions showed that the risk factor-based portfolio alone would return 4.2% with expected risk of 6.2%, well below the fund's 8% assumed rate of return. Adding leverage of 1.1 times capital brought the portfolio's expected return up to 8% with risk of 13%. Including the expected 9.8% return — the illiquidity premium — of the 20% of the portfolio not being managed in risk factor-portfolio brought the expected return to 8.15% with 12.7% risk, Mr. Dahl said in the report.

Mr. Dahl said in the report that he believes “the biggest risk we face with this approach is the risk of being different ... excellence in this business can only be achieved by a willingness to stand alone.”

MOSERS, however, isn't standing alone; PKA also was willing to be an outlier. Mr. Ladefoged said it took the willingness of PKA's investment committee to be “open to change, to not be afraid of standing out from the crowd or of the `people' risk of wanting to blend into the crowd.”