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Thursday, July 8, 2010

Risk Parity: An "All Weather" Solution To Market Volatility Or A Potential Storm?

While not a mainstay in every institutional portfolio, investment managers and consultants alike are touting the benefits of a risk parity allocation to investors seeking new ways to provide long-term protection against volatile markets. "We're seeing it both ways (as a standalone and total portfolio strategy)," said CIO Erik Knutzen of Cambridge, Mass.-based investment consultant NEPC. "We've had discussions about applying them on a total portfolio basis, or more theoretically with the overall asset allocation where risk exposures are balanced and broadly diversified." In the foundation or endowment space, there is at least one fund--the over $23 billion Texas Permanent School Fund--currently evaluating risk parity with NEPC. Jay Kloepfer, director of capital market research at investment consultant Callan Associates, said that interest in risk parity strategies among pensions has grown in the last five to six years and interest among nonprofits makes sense. "The main investors are public pension plans and my suspicion is that is because public pension plans are not required to mark liabilities to the market, their goal is to keep reaching for returns and lower volatility," he said. "I think there's less interest on the corporate plan side since they are moving toward a different framework and have a different focus now, but I can also see this having an interest on a foundation and endowment level and would be surprised if they are not at least looking at it." While pensions such as the Vermont Pension Investment Committee and New Mexico Educational Retirement Board have allocated to the strategy since June 2009, both through AQR Capital Management and New Mexico also through Deutsche Asset Management, the real test for risk parity managers going forward will be in areas such as the foundation and endowment space, where investors must truly keep a long-term view when signing on to the strategy that could have them cringing in poor fixed-income markets. Understanding Risk Parity Following yet another large drop in the equity markets nearly two years ago, investors have been generally frustrated, but are also seeking products that can be an all-weather asset class against the fartoo-often-occurring "perfect storms" in the market. Looking at the advent of risk parity as an investment strategy is most easily understood by comparing it to the concept of a "balanced" portfolio. Risk parity essentially takes the idea of a balanced portfolio up a notch by adding assets such as commodities or TIPS for an inflation hedge to the standard concept of equities as a growth driver and the use of various types of fixed-income that can be levered as a deflation hedge. "Balanced mandates have gone away and [risk parity] is almost a reintroduction," Kloepfer said. July 8, 2010 Nonprofit News Page 1

"Managers trying to find new ways to be tactical or asset allocators had hired a bank trust department and made decisions and then broke that off into pieces. This is almost a return to balanced, and that's why it's also seen as a total portfolio focus, rearranged and levered and with a different return stream." What risk parity managers have argued, though, is that in reality, a balanced portfolio is not so balanced at all from an equity volatility standpoint. "Think about what conventionally would be considered a balanced portfolio--60% equities and 40% bonds. That portfolio is fine, but is anything but balanced if you consider how much risk is coming from stocks," said Jeff Knight, cio for global asset allocation at Putnam Investments. "Even when we have a big negative correlation between stocks and bonds, most of the volatility in a balanced fund has come from stocks for long stretches of market history. No one has been too bent out of shape about this because the market has gone up, but in the last 10 years, the market has not been going up, forcing some interesting questions like 'should we have so much risk tied up in equity markets?'" This is where risk parity comes into the picture. Where balanced portfolios are constantly shifting the equity and fixed-income weight one way or another, risk parity managers attempt to lower volatility by levering the fixed-income side of the portfolio. Since inception in June 2006, the strategies have done well against their benchmarks, with Putnam's total return risk parity product returning 6.33% gross of fees in May. As of March 31, the product returned 7.56% compared to its benchmark, a blended 50% MSCI World Index and 50% Citi World Government Bond Index, which returned 3.69%. "When you compare risk parity portfolios with equities, the risk is coming in more balanced ways and is not dominated by equity volatility," Knight said. Should Investors Fear the "L" Word? For all the benefits that managers and consultants believe can come with using a risk parity portfolio, Ben Inker, director of asset allocation at investment manager GMO, makes a compelling case against the use of such portfolios in favor of balanced mandates. Inker believes that the benefits surrounding risk parity can be characterized as an "illusion" and harbor numerous risks, one of which is tied to leverage. "Leverage is a dangerous tool for investors. While it allows investors to magnify returns, it adds an element of path-dependency to them," Inker wrote in The Hidden Risks of Risk Parity Portfolios in March. "An unlevered investor can generally afford to wait for prices to converge toward economic reality, but a levered investor may not have that luxury." Inker further says that while risk parity portfolios performed well in recent years, their returns can be attributed to markets that were outside the realm of normal, and that there is not enough analysis to prove that those portfolios will be able to do so again. Knutzen said that NEPC's research has shown that with skilled managers, risk parity strategies are poised to perform better than balanced strategies over the long-term. "It may appear to be a challenging time to lever government bonds, but at any given moment there's as much chance interest rates go down as up. And this is also why we recommend combining these strategies with active asset allocation abilities," he said. "Overall, we think balancing risk among the different investment components is the right way to go about portfolio construction." Kloepfer noted the other issue for investors is the risk of underperforming an equity-laden portfolio. "If you take a longer term view, one of the challenges is that over an extended period it could underperform an equity heavy portfolio, and to think about that in the 1990s when equities ran to the sky, it is hard to maintain a risk parity portfolio because it would have underperformed by 20% a year," he said. July 8, 2010 Nonprofit News Page 2

"You have to convince and remind constituents why you did it, unfortunately lots will lose faith, and you can argue that people have lost faith (in the strategy)," Kloepfer added. Where Risk Parity Fits Into Portfolios Investors such as the Texas Permanent School Fund have said they may allocate as much as 7% of their portfolio to risk parity, and Knutzen said NEPC's view is that to be effective, investors would need to allocate at least 5%. Knutzen said that the firm recommends risk parity managers as a portion of a fund's global tactical asset allocation and that the influx of strategies by well-known managers such as Putnam, Bridgewater Associates and Wellington Management Company have warmed investors to the idea of making a commitment. "We're looking at shops that have a dedicated GTAA (global tactical asset allocation) team...with the active allocation abilities to adjust underlying beta exposures," he said. "With changing market dynamics it's important with the different weights and leverage amount levels to have teams with risk management capabilities to monitor and structure leveraged strategies." For nonprofits that might not consider making a separate asset class for risk parity, Knight said that investors can use the strategy as a liquidity tool that can be used as part of a multi-tiered approach to its absolute return alternatives approach. "It's not crazy to think about risk parity as a component of a diversified portfolio, sitting alongside other absolute return-oriented strategies," Knight said. "A plan that is raising its allocation to hedge funds and private equity or other things they consider to be less stock-market sensitive, might conclude that risk parity fits alongside those strategies because these strategies seek the same kinds of returns, the same kinds of consistency and have a better chance than traditional strategies of getting positive returns in different market environments." Other investors have essentially taken the framework of risk parity and applied it to their entire portfolios, having global equities, inflation and deflation hedging instruments and diversifying strategies such as low volatility hedge funds. Regardless of the method of implementation, Knutzen said investors need to understand their priorities for gaining returns with the most downside protection. "The big question people have to grapple with is 'what is the downside protection capabilities?'" Knutzen said. "In the recent financial crisis, while there were no positive returns, risk parity had better relative returns than a typical 60/40 portfolio or more traditional assets. We've been in a stressed environment, where leveraged strategies did better than unlevered."

July 8, 2010

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