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Investors getting better ways to gauge risk-parity success

PanAgora’s Edward Qian, a pioneer in risk parity, said current indexes aren’t really accurately tracking the strategies because too many asset classes are involved.

Newer indexes help fill a long-neglected need for accurate measuring

The investment industry is slowly catching up with investors' need for more accurate benchmarking of risk-parity strategies.

Asset owners have lacked an appropriate performance measure to gauge the performance of their risk-parity investments since the strategy debuted on the institutional investor stage a dozen years ago, sources said.

But the industry's first commercial risk-parity indexes only were introduced within the past two years.

In 2017, Chicago-based Hedge Fund Research Inc.'s peer universe-based, non-investible HFR Risk Parity indexes was launched.

In 2018, New York-based Standard & Poor's Financial Services LLC created investible risk-parity indexes composed of futures contracts for three asset classes — equity, fixed income and commodities.

Both firms offer the indexes in versions that match the expected 10%, 12% and 15% volatility targets of risk-parity strategies.

The commercial risk-parity indexes are producing returns that are "getting closer to the strategic asset allocation of a risk-parity approach with less tracking error," than commonly used risk-parity benchmarks such as a U.S. or global 60% equity/40% bond composite, said Robert "Bob" Prince, co-chief investment officer of Bridgewater Associates LP, Westport Connecticut.

For example, Bridgewater's All Weather risk-parity strategy has a 3.5% tracking error against the 10% volatility target version of HFR's risk-parity index and 5.5% compared to the 10-volatility S&P risk-parity index, which are better than the 8.5% tracking error vs. a 60% equity/40% bond allocation.

Bridgewater manages $160 billion, $75 billion of which is managed in the All-Weather strategy.

A new entrant — Wilshire Analytics — will debut new risk-parity indexes in the next month or two. The new index family stems from a research project initiated some years ago by sister company Wilshire Consulting in response to questions from institutional clients about better ways to benchmark risk-parity strategies, said Steve J. Foresti, managing director and chief investment officer of the consulting practice, Santa Monica, Calif.

Wilshire's team created an internal benchmark, which captures how risk-parity managers invest across three main factors — growth (equity), safety (fixed income) and inflation-sensitive assets (commodities) — as well as targeted volatility in both the short and long term.

Wilshire's clients used the benchmark as one of several to measure the performance of their risk-parity investments, Mr. Foresti said, and more recently, expressed demand for a tradable transparent version of the benchmark that they could find managers to implement.

The soon-to-be launched indexes use published indexes to determine the components of the asset classes and gain exposure through derivatives. Mr. Foresti declined to describe the new indexes and their target volatility levels.

The advantage of the tradable risk-parity indexes for investors is the transparent performance attribution as well as "a steep discount for a risk-parity strategy. It's a compelling story for investors," he said.

He declined to provide the cost of subscribing to Wilshire's indexes but estimated the total cost for the investor of hiring a manager to run a strategy based on a Wilshire risk-parity index would be less than half the 35-basis-point cost of a traditionally managed turnkey risk-parity portfolio.

Mr. Foresti declined to name Wilshire clients that use its internal benchmark or those considering the new indexes for benchmarking existing investments.

Because the strategies are new, isources said they could not comment on Wilshire's forthcoming risk-parity strategy indexes.

Very difficult

Consultant and managers agreed that benchmarking risk-parity portfolios is very difficult because the range of systematically managed investments portfolio managers use is very broad, including systematically managed equity, fixed income, commodities and credit.

Coupled with varied levels of targeted volatility and leverage applied to portfolios, sources said traditional benchmarks used by investors to evaluate risk-parity portfolios such as a global or U.S. 60% equity/40% bond portfolio, the consumer price index plus 5% or Treasury Bills plus 6.5% just don't work.

"There is no standard index for risk parity like there is for large-cap equity managers because risk-parity strategies include so many different asset classes," said Edward Qian, chief investment officer and head of research for multiasset strategies at PanAgora Asset Management Inc., Boston.

Mr. Qian, one of the industry's first researchers and managers of risk-parity strategies, said existing benchmarks do not capture the return profile of the strategy, noting that the HFR indexes provide an average return of the risk-parity managers that report returns to Hedge Fund Research, but the index isn't implementable.

By contrast, he said the S&P risk-parity indexes are implementable but the results are "qualitatively and quantitatively different than what risk-parity managers produce."

PanAgora manages $46 billion; with $15 billion in risk parity.

Kevin Machiz, vice president in capital markets research for Callan LLC, San Francisco, agreed regarding market-based risk-parity indexes like those from S&P, stressing "investors need to be careful about utilizing these indices. They may have a similar performance pattern to active risk-parity managers in some time periods, but not others."

"Active risk-parity managers did not look at these indices before designing their investment strategies and do not attempt to track them over time," Mr. Machiz added.

In fact, consultants and risk-parity managers stress the importance of benchmarking a risk-parity portfolio to its specific expected return, instead of to a benchmark over a long horizon of at least 10 and preferably 20 years (P&I, March 4).

"The starting point for investors to understand is that risk parity more efficiently allocates assets over time than traditional stock and bond portfolios, for example, a global or U.S. 60%/40% portfolio. It will never look anything like a beta benchmark over 10 years or even 20 years to satisfy an investor using that benchmark," said Rhett Humphreys, partner in the Atlanta office of consultant NEPC LLC.

Managing expectations

For Bridgewater Associates, the industry's largest risk-parity manager, managing expectations is key to investor understanding and satisfaction with the strategy.

Benchmarking risk parity doesn't work in the same way as other strategies, said Mr. Prince.

"Some investors are trying to benchmark risk parity with an alpha benchmark" as they would gauge whether a traditional actively managed strategy outperformed a passive benchmark, Mr. Prince said, rather than "benchmarking the strategic allocation against the return expectation."

"Investors who do this are trying to jam a square peg into a round hole," he said.

Bridgewater advises All Weather investors to judge the strategy's return against its target return of 6% plus cash and suggests that investors who may want to compare the strategy's results against other risk-parity approaches use one of the published risk-parity indexes.