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Risk-parity investors do a bit of second-guessing

NEPC’s Rhett Humphreys

A cadre of asset owners are suffering from a crisis of confidence in their risk-parity investments.

Some institutional investors are questioning the efficacy of their risk-parity investments — which are designed to provide a high degree of diversification with systematically managed equity, fixed income, commodities, credit and other investments — because they have not met return expectations in the short term.

Investment consultants including Boston-based NEPC LLC and Wilshire Consulting, Santa Monica, Calif., said they are fielding questions and working with clients to review their commitments to risk-parity strategies.

NEPC, for example, will spend the next 18 months collaborating with clients to re-evaluate their risk-parity investments, said Rhett Humphreys, an Atlanta-based partner.

One reason asset owners are scrutinizing their risk-parity strategies is the sheer difficulty of determining whether the investments are meeting expectations. Performance evaluation isn't straightforward for investors, Mr. Humphreys said, because there currently is no single standard or appropriate benchmark to compare risk-parity strategies.

Investors also may be outgrowing the need for risk-parity strategies, he said, noting that when the strategies first gained attention about a dozen years ago, most portfolios were largely composed of plain-vanilla stocks and bonds.

Risk-parity approaches offered broad portfolio diversification into new asset classes within a single strategy, but now pension funds routinely invest using a much broader asset allocation that includes many of the same asset classes used in risk-parity strategies, Mr. Humphreys said.

"Risk parity now is at the margins for many investors because portfolios now are so much more diverse. At this point, risk parity can slightly decrease risk over 10 years" but doesn't play the same broad diversification role it once did, Mr. Humphreys said.

Questioning allocations

Among investors questioning their risk-parity allocations are the $34 billion Texas Permanent School Fund, Austin, and the $2.4 billion Austin (Texas) City Employees' Retirement System. Both are considering eliminating risk parity from their portfolios or moving to a cheaper, passively managed replication approach.

The $51.8 billion Teachers' Retirement System of the State of Illinois, Springfield, reduced its allocation to risk-parity strategies by $500 million in 2018 as part of a change in its annual strategic asset allocation. Fund spokesman David Urbanek declined to comment on the rationale for cutting the risk-parity allocation to $477 million.

Even plans heavily committed to risk parity, like the $28.7 billion Indiana Public Retirement System, Indianapolis, which has 12.7% of assets to the strategy, will be giving the approach a close look in its 2020 asset-liability study.

Chief Investment Officer Scott Davis said in an email that "the investment staff will be working with INPRS' board to evaluate various asset classes," noting that staffers "remain confident" about risk parity, but "will give it careful consideration" in the forthcoming review.

Consultants stressed that part of the problem for asset owners used to evaluating investments on a quarterly or yearly basis is the long time horizon — 10 to 20 years — for risk-parity strategies to achieve the goal of topping whatever benchmark is selected by the investor.

For example, members of the Committee on School Finance/Texas Permanent School Fund, which oversees investments, were asking tough questions about the fund's risk-parity investments at a Jan. 31 meeting.

Strategies managed by Bridgewater Associates LP and AQR Capital Management LLC, which totaled $2.3 billion as of Aug. 31 according to the Texas fund's latest annual report, significantly trailed the fund's 60% U.S. equity/40% U.S. fixed-income benchmark by an aggregate 456 basis points for the quarter ended Sept. 30 and 458 basis points for the five-year period, according to a webcast of the meeting.

B. Holland Timmins, executive administrator and chief investment officer, told the committee the fund's risk-parity strategies "certainly failed to meet the objectives of the asset class at a significant cost to the fund." He also noted that the strategies brought down the fund's total return for the quarter ended Sept. 30 by 13 basis points to 2.1%.

Committee members agreed to consider the role of risk parity in the overall portfolio during the fund's asset allocation review scheduled for 2020.

Mr. Timmins did not respond to an email request for more information about the permanent fund's risk-parity investments.

The size of the individual portfolios managed by Bridgewater and AQR could not be learned, but the aggregate return of the total portfolio was an annualized 5.41% for the five years ended Aug. 31, trailing the 9.69% return of the fund's 60/40 benchmark composed of the S&P 500 index and the Bloomberg Barclays Capital U.S. Aggregate Bond index.

Warning about short-termism

Consultants and managers alike cautioned against short-termism in evaluating risk-parity performance.

"We're fans of the concept of risk parity and have done a lot of work over the years for many pension plans," said Steven J. Foresti, managing director and chief investment officer at Wilshire Consulting, Santa Monica, Calif. "We like the strategy because it generates long-term returns and smooths the return stream while maximizing diversification."

But he stressed the time horizon for evaluating returns is a 20-year period, which can be confounding for some investors from a behavioral finance perspective. "You've selected an asset allocation with a long horizon and it's fine to keep an eye on it. A three- or five-year rolling period is appropriate, but you can't measure the success of risk parity over a quarter," he said.

John J. Huss, principal and a portfolio manager for AQR's multiasset portfolios including risk-parity strategies, agreed, noting that "in any given year, all you really observe is the risk. You only see the compensation over the long term."

Assets managed in risk-parity approaches by Greenwich, Conn.-based AQR totaled $24.9 billion as of Dec. 31.

The issue for the Austin City Employees' Retirement System about its $112 million investment in the AQR GRP EL Fund II LP is whether risk parity even has a place in the $2.4 billion portfolio, said CIO David T. Veal, noting that the fund's 4.6% allocation isn't enough to add significant diversification relative to a 60% equity/40% bond portfolio.

The fund also is expensive at 35 basis points, and AQR has been on watch for nine months because portfolio managers are only providing half of the fund's promised 10% volatility target.

The Austin fund's risk-parity fund's returns for periods ended Dec. 31 were -6.1% for the year (vs. -4% for the benchmark); 5.2% for three years (3.9%); and 2.1% since inception on Feb. 1, 2014, (2.3%). The fund's benchmark is the S&P Risk Parity Index 10% Target Volatility. Multiyear returns are annualized.

As part of the fund's new premier manager list structure, the fund's board will approve U.S. equity managers and risk-parity managers if Mr. Veal and his staff decide to maintain an allocation to the diversification strategy.

The launch of new risk-parity indexes by Standard & Poor's Financial Services LLC in August caught Mr. Veal's eye, and he's found a money manager to replicate the S&P risk-parity index passively for just 10 basis points. "You used to have to manage risk parity actively because these indexes didn't exist," Mr. Veal said.

Confidentiality rules prohibit Mr. Veal from naming the potential manager until the board has cleared the firm to join its premier list.