“As long as investors expect bond yields to go up more in the future than they actually do – for example by having exaggerated inflation expectations – bonds will generate a decent return even with yields being unchanged.”
Valuation, valuation, valuation
But valuation is the key to success, says Hassel, whether you pursue risk parity or not. “It does not matter if you see valuation as a part of your long-term strategic asset allocation or part of your active investment strategy. The key thing is that you use your advantage as a long-term investor to buy cheap assets and sell expensive ones at what seems to be extremes.”
Redington head of manager research Pete Drewienkiewicz is an advocate of risk parity. He sees it as getting volatility contribution from each asset class or risk bucket depending on how it is approached. “We look at risk parity under the umbrella of alternative beta – a multi-asset strategy attempting to derive returns from the right beta stream at the right time,” he says. “When an asset class is more volatile, a risk parity strategy will reduce exposure to it and when less volatile, it increases exposure.”
This does bring risk, he says, but it is manageable and there are more fundamental reasons why he can see it appealing to UK pension schemes. “Rebalancing daily or weekly to the right amount of risk for each strategy is a natural sell high and buy low approach that allows you to take your profits. It also gives a lot of UK clients exposure to segments they wouldn’t necessarily have exposure to, such as commodities. Normally the inflation bucket is index-linked bonds and commodities, which UK pension schemes usually hold a lot of so is a useful diversifier.”
And schemes are starting to turn on to risk parity’s potential as an application of risk analysis, says MSCI head of risk and analytical research Kurt Winkelmann. But there are constraints to what risk parity can do, even for individual schemes. “Larger pools of institutional capital have carved out areas of their portfolios they can test out the ideas but the larger they get, the more they are risk constrained,” he says.
But there are also only so many highly liquid exchange-traded assets available at any one time, says Winkelmann, adding further restrictions to risk parity’s application. “If [the scheme uses] risk parity on the entire portfolio, they would bump into capacity issues quickly, but they can still embrace the concept with trial portfolios and strategic tilts into the rest of the portfolio.”
Monitoring is essential, not only for the management of risk, but as the portfolio becomes more granular it becomes more difficult to determine the influencing factors. Organisations with a strong risk management structure and risk discipline will be better able to determine the effectiveness of the strategy, says Winkelmann.
“It does tend to be the bigger institution that has implemented risk management and monitoring and has the bandwidth to consider the ideas and the culture, analytical systems and governance structure but they may be constrained by being too big.”
A growing appetite
AQR’s Mendelson agrees risk parity investing is not an all or nothing approach, and currently sees 5 to 15% allocations, but sees that increasing in time. “Risk based investing will become more commonplace. People are investing very much on the opposite side of equity concentration and getting some measure of diversification.”
It is also not expensive, says Peters: “We charge the same as any regular balanced fund, with a very low costs basis, around the 50bps mark for institutional investors. It is not an index fee but nor is it a hedge fund fee, either.” Where else might you get the same kind of promise as a hedge fund, but with a fixed fee, he asks?