Investors keep a watchful eye on the horizon for risk

Institutional investors increasingly are embracing myriad volatility management strategies in an effort to control downside portfolio risk and still meet long-term return goals.

Sophisticated investors that implemented portfoliowide volatility management over the past few years — such as the C$47.4 billion (US$46.8 billion) Healthcare of Ontario Pension Plan, Toronto, and the $3.4 billion Fairfax County (Va.) Employees' Retirement System — have racked up strong track records of impressive returns that outperformed their benchmarks and their peers while keeping risk at bay.

The volatility-management options include individual low-volatility equity and bond strategies as well as global absolute-return funds; risk-parity and liability-driven portfolio construction; derivative overlays; and portfolio-level volatility control.

Like other large Canadian public pension plans, nearly all of HOOPP's portfolio is internally managed, using a liability-hedging portfolio consisting primarily of long government bonds, real return bonds and real estate with an overlay strategy of options, swaps and futures for equity exposure. There is also a 30% allocation to return-seeking investments.

The only stock picking in the portfolio comes from long/short equity strategies within the absolute-return portfolio. The rest of the equity exposure is obtained through derivatives in global stock markets, said James Keohane, president and CEO. The pension fund's derivatives contracts include foreign exchange forwards, equity and bond futures, and a variety of swaps and options with a total notional value of about $173 billion.

“We can actively construct the portfolio for better liability matching through derivatives,” Mr. Keohane said.

HOOPP returned 17.1% in 2012, outperforming its customized internal benchmark by 281 basis points. For the 10 years ended Dec. 31, the pension fund returned an annualized 10.3%, vs. 8.9% for its benchmark.

The pension plan's funded status is 104%.

“There will be scenarios where we underperform ... but our real objective is to have assets outperform liabilities,” Mr. Keohane said.

Officials at the Fairfax County employees' fund, on the other hand, designed their own risk-parity strategy for the entire portfolio that leverages up fixed-income investments coupled with a variety of derivatives.

The portfolio is “designed to follow a balanced risk approach. We're out to take the same level of volatility overall that a traditional 60/40 portfolio would have, but get a better Sharpe ratio over time,” Laurnz Swartz, chief investment officer, said in an interview.

Mr. Swartz oversees investment of the $5.8 billion Fairfax County Retirement Systems, which comprises three pension funds: the employees' plan; the $1.1 billion Police Officers Retirement System; and the $900 million Uniformed Employees' Retirement System.

While the employees' plan runs a risk-parity approach over its entire portfolio, the police officers plan has made a partial allocation of 30% of plan assets invested equally in risk-parity strategies managed by BlackRock Inc., Bridgewater Associates Inc. and AQR Capital Management LLC, Mr. Swartz said in an e-mail. The uniformed employees fund has not yet made a risk-parity allocation.

“The differences in approach across the systems reflect a combination of the fact that we have three distinct boards with three different consulting relationships,” he wrote.

The employees plan's portfolio has 20% allocated to diversified alpha strategies, such as global macro, multistrategy and distressed credit hedge funds. The other 80% of plan assets are invested in a beta portfolio with an asset allocation of 90% fixed income, 30% equity, 7.5% real estate and 5% commodities. The sum of the total allocation is greater than 100% because of portfolio leverage.

The risk-parity approach reduces plan risk through a significant reduction in equity exposure compared to a standard asset allocation model. The pension fund leverages up the less volatile assets, mainly bonds, to a point where the plan is achieving the same point of returns from bonds as from equity, Mr. Swartz said.

That strategy is working: As of Dec. 31, the Fairfax County Employees' plan had annualized three- and 10-year returns of 15.4% and 10.4%, respectively, compared with 9.96% and 8.39%, respectively, for the same periods for the plan's customized policy benchmark.

Other pension plans have followed Fairfax County's lead by adding or searching for risk-parity managers, albeit not on a portfoliowide approach:

• The $11.2 billion Ohio School Employees Retirement System, Columbus, invested $100 million in its first risk-parity strategy, Bridgewater's All Weather Portfolio;


• The $3.5 billion Ventura County (Calif.) Employees' Retirement Association is expected to allocate 7% of assets, or $245 million, to global tactical asset allocation and risk-parity strategies at its April 15 board meeting; and


• The $402 million Chicago Park Employees' Annuity & Benefit Fund is searching for a risk-parity manager to handle a $20 million first-time allocation.

The typical 5% to 10% allocation that most pension plans make to risk-parity strategies is likely to have only a modest impact on controlling overall portfolio volatility, said Joseph Nankof, partner and consultant with Rocaton Investment Advisors LLC, Norwalk, Conn.

“I think we're going to start to see risk parity adopted at the portfolio level as a next-generation strategy,” Mr. Nankof said.

Risk parity is “probably the poster child of this current market environment ... (but) asset allocation solutions are certainly widespread,” said James McKee, senior vice president and director of hedge fund research, Callan Associates Inc., San Francisco.

Volatility management is a good strategy for funds that know their decision-makers will be in place for a long time, but with turnover comes “decision risk” that could result in plans pulling the plugs on volatility-management strategies because they are losing out on the upside, Mr. McKee said.

Many pension plans are simply using broader diversification or investing in specific low-volatility strategies to provide a level of downside protection for specific asset classes.

The $3.5 billion Colorado Fire & Police Pension Association, Greenwood Village, structured its global equity portfolio specifically to manage volatility, allocating 20% to different hedge funds to help minimize drawdown risk. The hedge funds have a long bias with a 0.7 beta compared to the market.

“We're still trying to capture the lion's share of returns,” said Daniel Slack, CEO.

There is also a separate 11% allocation to absolute return that has a much lower beta of 0.2 to 0.3. Mr. Slack said the absolute-return portfolio does not capture the big bull markets, but serves as a hedge against downside risk.

In another move to lower volatility, the plan hired AQR Capital Management LLC last month to run $106 million in an active, low-volatility emerging markets equity fund.

The $279 million pension plans of Mitsubishi Motors North America Inc., Cypress, Calif., hired SEI Investment Co.'s institutional group as outsourced CIO and to construct a portfolio to improve its funded status while reducing risk. Mitsubishi has a 21% allocation to SEI domestic and global managed-volatility strategies, which have been in place for about two years. Those strategies are coupled with a long-duration bond glidepath to limit the risk. The pension plan invests a little less than 20% in long-duration bonds, an allocation that will increase to nearly 30% when the funded status reaches 90%. The funded status was 86% at the end of February, up from 70% at the end of 2011.

“We needed to maintain equity exposure to build up the funding percentage, but we didn't want to expose ourselves more than we had to for drawdown phases,” said Andrew Whaley, Normal, Ill.-based director of finance for Mitsubishi Motors North America.

The pension plan returned 15.2% in 2012, well above the median 12.82% for corporate pensions reported in the Wilshire Trust Universe Comparison Service.

The managed-volatility strategies have performed as expected, providing downside protection in a tepid 2011 by outpacing their benchmarks by about 10 percentage points and underperforming the broad equity markets during a strong 2012 by about three percentage points. The SEI strategies are run through stock selection without the use of derivatives.

Absolute-return strategies are another way to dampen volatility.

The £3 billion ($4.54 billion) Standard Life Investments pension fund is 96% invested in its own global absolute-return strategies, which were originally conceived in 2005 to help improve the plan's funded status. The pension plan is now fully funded, rebounding from a 20% deficit before GARS was in place.

SLI takes on one-third to one-half the risk of a typical equity strategy in its global absolute-return strategies, which invest in 20 to 30 different underlying liquid strategies, including global real estate investment trusts, U.S. high yield, European investment-grade fixed income and a variety of “vanilla” derivatives that control volatility while still delivering strong returns, said Euan Munro, Edinburgh-based global head of multiasset investing and fixed income. There are no illiquid investments in the strategies, which have about $34.3 billion in assets and an annualized volatility of 5.86% since inception, as of Dec. 31.

“We are trying to build a fund that could be the entire solution,” Mr. Munro said. “We're trying to build a portfolio that survives not the most likely economic environment, but quite a few outcomes, including some that are quite messy.”

While SLI's pension plan is almost entirely invested in GARS, most pension funds have been more likely to dip their toes into volatility management strategies with smaller allocations.

The $2 billion Louisiana Sheriffs' Pension & Relief Fund, Baton Rouge, hired Russell Investments to manage $30 million in a manager-of-managers defensive equity strategy as part of a trial allocation to a low-volatility approach to reduce risk (Pensions & Investments, Nov. 2).

In January, the 200 billion Danish kroner ($36 billion) PKA, Hellerup, Denmark, hired Acadian Asset Management LLC to run a $450 million managed-volatility strategy as part of a revamp of its equity investment process.

PKA, which is owned by five Danish occupational pension funds, moved to a risk-factor investment process that allocates to 17 different risk premiums within the equity portfolio and abandoned traditional strategic allocations to regions.

The C$172.6 billion Canada Pension Plan Investment Board, Toronto, uses a total portfolio, or risk-factor approach, to managing its pension plan. Each investment is assessed by the underlying risk and return attributes. CPPIB does not target specific asset allocations for individual asset classes.

Endowments are also investing in low-volatility equity as well as managed futures and commodity trading adviser strategies in the hedge fund area in an attempt to control left-tail risk, or market downturns, said Fredric “Rick” Nelson, CIO of Commonfund Inc., Wilton, Conn.

Tail-risk strategies, which seek to reduce the impact of extreme market downturns of 20% or more, tend to be more popular with university endowments because investment officials need to preserve the funds' ability to meet the institution's spending rate, sources said.

Widely considered to be among the most sophisticated users of tail-risk approaches, the University of Chicago has allocated 2%, or about $130 million, of its $6.5 billion endowment fund to active long volatility strategies that seek to make money during severe market declines (P&I, April 2, 2012) and thus mitigate declines in other parts of the portfolio.

Corporate defined benefit plans have picked up on the benefits of tail-risk hedging from their endowment cousins and are increasingly using option strategies to protect both the bond portfolio of a liability-driven approach and the equities in the growth portion of the portfolio, said Matthew Clink, partner and head of U.S. portfolio management, Hewitt EnnisKnupp, Chicago.

Once a company has derisked its defined benefit plan to improve its funded status, dynamic hedging using a risk-parity approach gives the plan sponsor more flexibility to manage the equity exposure and interest-rate risk of the dual portfolio, he said.

Mr. Clink declined to name any of the firm's corporate clients that use tail-risk hedging or risk-parity approaches.