Redington’s Drewienkiewicz has seen evidence of UK investors making small 2 to 4% allocations, but does not anticipate rapid growth. “There is a slight scepticism about systematic investment,” he says. “People in this country do not like what they see as black box strategies. I do not think risk parity is as much a black box as some other strategies and I can see them replacing some equity risk at the margins up to 10 or 15%.”
He also believes the use of risk parity is unlikely to be restricted to large schemes: “These strategies are most useful for smaller clients as risk parity almost provides a one stop diversification shop, like doing DGF for smaller schemes. I think they will prove suitable for DC as well.”
The idea that risk-adjusted returns should be similar for different asset classes in the very long run is reasonable and a good starting point for any analysis, says USS’s Hassel, and makes the most of diversification benefits. “Most pension funds have moved towards more diversified portfolios and this trend is likely to continue. “Diversification is one of the few free lunches around and it makes sense to make the most of it.”
Leverage – and why you shouldn’t be afraid of it
There are two topics that come up more than any other when talking about risk parity and they are bonds and leverage, says AQR Capital Management principal Mike Mendelson.
“Risk parity is not a panacea. It helps give an institution a little bit higher risk adjusted return,” he adds. “Hopefully all you are doing is giving yourself risk-adjusted returns, not trying to do anything heroic. Institutional investors are already using leverage in hedge funds, real estate and so on. It is about the judicious use of leverage, not what happened to make the world the way it is today.”
Risk parity strategies may use leverage, but those levels are fairly constant and managers only invest in highly liquid assets, the risk parity managers argue.
It is important to recognise that lots of people use leverage all the time, agrees Redington head of manager research Pete Drewienkiewicz. Clients use leverage to take equity/gilt exposure through synthetics and the gilt repo market respectively and he believes leverage is not such a concern for the UK pensions sector as might be anticipated, as risk parity managers are using robust leverage of liquid instruments that are exchange traded. Even at height of Lehman, you could buy and sell futures on exchange and only put up initial margin, he says.
“If leverage is done in sensible ways and risk managed, you can be comfortable with it,” says Drewienkiewicz. “The overall strategy is risk factor and volatility focused rather than notional and there is leverage in equity holdings if they are of companies with a lot of borrowing, so you will still be exposed.
“But it is important to be aware of the nature of the leverage and risk manage it properly. This is extremely important in all multi-asset investing.”