Risk-parity benchmark surfaces

Institutional investors, money managers and a hedge fund index developer collaborated to create a series of investible risk-parity benchmarks that's catching the attention of chief investment officers, investment committees and trustees.

The new risk-parity indexes were developed by Hedge Fund Research Inc. in collaboration with the $81 billion Ohio Public Employees Retirement System, Columbus, to solve the problem investment staff encountered in finding an appropriate benchmark for the fund's $4 billion risk-parity portfolio.

In 2012, OPERS allocated 5% to risk parity — "a rules-based leveraged investment strategy" — but the benchmark for the portfolio assumed the allocation was to unleveraged stocks and bonds, said Richard D. Shafer, chief ​ investment officer, in a memo to the board of trustees.

The resulting disconnect between the returns of OPERS' risk-parity portfolio and its benchmark resulted in tracking error of more than eight percentage points over a three-year period, Mr. Shafer said, prompting investment staff and the fund's investment consultant, NEPC LLC, to try to "improve the fit" because "no common industry benchmark existed."

OPERS provided "active assistance" to HFR in creating the peer-group risk-parity indexes and staff has found that "OPERS' realized results now closely match the HFR Risk Parity Vol 15 Institutional index (back-tested),'' Mr. Shafer said in the memo.

The Ohio public employees' risk-parity benchmarking dilemma is universal, sources said.

"Risk parity is a blanket term that covers a very large universe of investment approaches that tend to be very different from each other,'' said Colin Bebee, senior vice president and consultant at Pension Consulting Alliance LLC, Portland, Ore.

"It's a portfolio construction, an asset allocation strategy, rather than a traditional asset class," Mr. Bebee said. "You end up with an apples-to-oranges comparison if you try to compare individual managers," a problem that is exacerbated when investors try to find a suitable benchmark for comparison with a multimanager risk-parity portfolio, he added.

"Everybody needed (an index like) this but nobody had asked us to create one," said Kenneth J. Heinz, president of Chicago-based HFR, adding that "risk-parity managers have wanted something like this for a long time."

HFR, best known for its extensive range of peer group-based hedge fund indexes, applied the same portfolio construction methodology to build the risk-parity indexes.

Index construction equal-weights a peer universe of 25 risk-parity strategies managed by 16 money managers with aggregate risk-parity assets of about $110 billion.

The indexes are based on three levels of volatility targets: 10% (or less); 12% (with a range of between 10% and 15%); and 15% (or greater).

Each volatility level also offers an institutional version, for risk-parity strategies with at least $500 million under management.

Sister company HFR Asset Management is prepping a series of manager-of-managers tracker funds for investors who want to invest in the entire universe of each equal-weighted index.

Mr. Heinz declined to provide a list of the risk-parity managers in the HFR peer-universe indexes but sources said some of the industry's largest managers, such as Bridgewater Associates LP, AQR Capital Management LLC, Panagora Asset Management Inc., BlackRock Inc. and First Quadrant LP, are included.

Risk-parity managers' eagerness to provide historical returns and to assist HFR in creating the indexes was driven by recognition of the difficulty clients were having with benchmarking their approaches.

"Over the years, benchmarking risk-parity strategies has been difficult. Institutional investors have struggled with finding a good benchmark," said Michael Mendelson, principal and a portfolio manager of risk-parity investments for AQR Capital Management, Greenwich, Conn.

AQR constructed leveraged risk-parity indexes for its investors but there wasn't high adoption of them, Mr. Mendelson said, adding "we participated in HFR's effort because we see that our investors want to use them."

AQR managed $32 billion in risk-parity approaches as of Sept. 30.

"We think the HFR indexes are a good thing because a lot of investors are using risk parity for the right reasons and have to bear the consequences of having the portfolio compared to the wrong benchmark," said Robert Prince, co-CIO of Bridgewater Associates, Westport, Conn.

The HFR risk-parity indexes serve two purposes for investors, Mr. Prince said.

First, the indexes provide a frame of reference for whether the performance of an investor's overall risk-parity portfolio or of an individual manager is in the ballpark of other managers and can show whether active management by risk-parity managers in the portfolio has been additive.

Bridgewater managed $77 billion in its All-Weather risk-parity strategy as of Sept. 30, about 70% of the aggregate assets in HFR's risk-parity universe.

"The problem with risk-parity managers is that there's no standard way of doing it. Risk-parity managers don't even agree on what betas we are managing across," said Edgar Peters, partner and portfolio manager of risk-parity strategies at First Quadrant in Pasadena, Calif.

"HFR's risk-parity indexes are as applicable to what we do as the HFRI Macro index is to global macro hedge funds," Mr. Peters said, noting the peer-group approach is the "only way to get to a benchmark that's reasonable."

First Quadrant managed $2.5 billion in risk-parity strategies as of Sept. 30.

High tracking error between the actual return of a fund's risk-parity portfolio and its benchmark is a huge source of frustration.

Tracking error for actual portfolio returns and the most commonly used risk-parity benchmark — a 60% equity/40% bond risk-parity benchmark — is often 10 percentage points or higher, said Mr. Peters.

Institutional investors are experiencing tracking error problems similar to those of Ohio PERS.

For the year ended June 30, the 4.6% net return of the $2.9 billion risk-parity portfolio of the Indiana Public Retirement System, Indianapolis, trailed the benchmark by 980 basis points. By contrast, the net 7.2% return of the $4.5 billion risk-parity portfolio of the Pennsylvania Public School Employees' Retirement System, Harrisburg, for the 12 months ended June 30 was up 220 basis points over an internal benchmark return.

Frustration about the inadequacy of risk-parity benchmarks has been running high among institutional investors for years. "It's frustrating for pension fund trustees not to have a simple up-or-down benchmark they can use to evaluate the whole risk-parity portfolio or individual managers," said Christopher Walvoord, partner and global head of hedge fund research, Aon Hewitt Investment Consulting Inc., Chicago.

That irritation is pushing asset owners to take a close look at risk-parity benchmarking practices and at the HFR indexes, HFR's Mr. Heinz said. The firm is seeing interest from institutional investors in North America and Europe and to a lesser extent in Asia, New Zealand and Australia, he said.

The board of Ohio PERS is expected to give final approval to adopt the HFR Risk Parity Vol 15 institutional index for the fund's $3.9 billion risk-parity portfolio effective Jan. 1, an OPERS official confirmed.

The disparity also was on the minds of finance committee members for the $32.5 billion Texas Permanent School Fund, who expressed concerns about the disparity between returns of the $2.1 billion risk-parity portfolio and the benchmark during a July 31 meeting. The net return of the Permanent School Fund's risk-parity portfolio was 5.7% for the year ended June 30 compared to 10.3% for the 60%/40% benchmark.

The fund's consultant, Rhett Humphreys, a partner at NEPC, explained to committee members the problem is that the benchmark is "not a very good comparison" for the risk-parity portfolio and mentioned that HFR had developed the new risk-parity indexes.

The fund's investment staff isn't going to make a recommendation yet about whether to adopt one of the HFR risk-parity benchmarks. However, members of the finance committee will hear a presentation about the risk-parity asset class and discuss the fund's benchmarks at their next meeting on Nov. 9.

The board of the $52.2 billion Pennsylvania Public School Employees' Retirement System conducted its annual benchmark review for each asset class in September and the new HFR risk-parity indexes were discussed in detail as a possible benchmark for the plan's risk-parity portfolio, said James H. Grossman Jr., CIO.

The $142 billion Teacher Retirement System of the State of Texas, Austin, manages about half of its $7 billion allocation to risk parity internally. The performance benchmark is an equal-weighted blend of risk-parity strategies.

While staff have not recommended a change to one of the HFR indexes, Jase Auby, deputy chief investment officer, said it supports a widely adopted industry benchmark.