TRS defends struggling risk parity allocation for now

Although the Teacher Retirement System of Texas’s $11.2 billion risk parity portfolio has struggled of late, the pension fund remains committed to the strategy that it forecasts could perform better in the economic environment ahead. TRS, which manages around $170 billion, treats risk parity like an asset class and has increased the allocation over time in terms of both the risk level within the different buckets and size with the portfolio currently targeting an 8 per cent trust level allocation. The strategy of balanced risk exposures is designed to perform well in most market environments and is implemented both internally and via external managers.

Speaking at the Risk and Portfolio Management division’s annual update to the board in December, James Nield, chief risk officer, and Mark Telschow, director, RPM Portfolios, reported a difficult year for government bonds and risk parity, although risk parity has performed better in recent months. The problem, Telschow explained, is that virtually all assets apart from energy investments have declined and the strategy suffers when all assets perform badly. Something other investors like Denmark’s PFA say has caused them to lose faith in risk parity.

“When all asset struggle, risk parity is going to struggle,” said Nield. He also noted that risk parity does best when cash is unattractive, yet cash is currently outperforming other asset classes. “Risk parity is going to struggle as it is short cash,” he said.

Looking ahead, falling growth and rising inflation are likely consequences of Federal Reserve tightening. This could create an environment where risk parity does better. Moreover, risk parity tends to compound returns faster than in other allocations, so drawdowns are shorter and the acceleration better.

The team attributed the few bright spots in risk parity’s performance to successful manager selection (TRS uses Bridgewater, AQR and Invesco) and asset mix selection whereby the portfolio held fewer government bonds. TRS actively manages the risk parity tracking error to reduce the range of relative outcomes through both risk level and asset mix. Telschow also noted that cheaper internal management of some of the allocation created a tailwind.

The board heard how risk parity is complicated by the wide range of opinions regarding different risk and design models; what assets to include in the buckets and what risks to balance – whether that balance should be based on risk contributions or economic regimes, for example. Design decisions result in different portfolios and influence the outperformance or underperformance mean reverse over time. However, Telschow and Nield said there is not a huge amount of informational edge in design decisions.

Experimentation

Alongside running the risk parity allocation and a 16 per cent passively managed government bond portfolio, TRS’s 16-person Risk and Portfolio Management team is tasked with research initiatives and experimentation to help expand internal capabilities and reduce fees. The risk parity portfolio initially emerged from this process which has most recently focused on a new diversified and balanced commodities exposure, similar to the approach taken in risk parity. Launched in September 2022 the portfolio particularly aims to balance exposure to rising inflation.

Other tasks assigned to the Risk and Portfolio Management team include financing liquidity and setting liquidity targets, conducting repo activity, managing derivative trading, and finding the best way to source the fund’s cash needs. The team also rebalance the portfolio, optimise balance sheet and oversee securities lending, seeking additional yield where possible. Having these activities housed in one team means a tighter grasp not only on how much liquidity the fund needs, but also the best way to source it.

Asset allocation

The Risk and Portfolio Management team are also responsible for conducting an asset allocation study every five years. The last study, three years ago, led to TRS adding leverage, increasing its allocation to fixed income to add diversification, and boosting investments in private markets where TRS now invests 42 per cent of assets. Recent results show that the additional allocation to leverage has added 63 basis points of positive return, and more money invested in private markets has also been additive. However, adding to the fixed income allocation has had a negative impact.

The risk management team look at around 200 daily risk signals, reporting on macro and portfolio risks and putting in place action plans if needed. Recent action has focused on bubble signals, allocation and counterparty risks. In one example of the process at work, signals flagged risk in the asset allocation limits in the private equity portfolio vs the allocation through time. This ultimately led to raising the policy limit from 19 per cent to 24 per cent. Nield concluded that data is a key contributor to strategy success, enabling “drill through” analysis to enable more useful reporting.