The risk parity approach to portfolio construction might not deliver results in a “bull stockmarket,” but remained a “robust and rigorous” methodology which also “managed risk regret over time.”

These are the views of Wai Lee, chief investment officer of quantitive investment at New York-based fund manager Neuberger Berman, who was recently named winner of the 2012 Peter L Bernstein award for his article “Risk-Based Asset Allocation: A New Answer to An Old Question.” The article also won an award from The Journal of Portfolio Management.

Wai Lee’s article looks at new approaches to portfolio construction, from minimum variation to risk parity to maximum diversification to equal weighting, and follows on from his earlier work on “de-mystifying” risk parity.

Lee told top1000funds that at Neuberger Berman, which has US$203 billion under management, he was increasingly using risk parity to help clients construct their portfolios, but “tailored for clients because one size does not fit all.”

Risk parity portfolios allocate risk rather than capital, with the inevitable consequence of reducing the portfolio’s allocation to equities, and increasing the fixed income component.

“The risk parity portfolio takes equal risk on every position so that is a differentiator with other portfolios,” says Lee.

“In our portfolios, there are two measures of risk, one is volatility and the other is tail risk, so that means that when we construct a portfolio we have a volatility parity and a tail risk parity which combines with that to deliver an ultimate risk measure.”

Lee acknowledges that while risk parity portfolios have proved resilient in the market turbulence since 2008, suggestions that it was an approach best suited to bear markets were “over generalized.”

“We like risk parity because it produces robust portfolios,” he says.

“If you have a great bull market in stocks, and you are in a risk parity portfolio which is not concentrating risk, then it is hard to imagine that a risk parity portfolio will outperform a portfolio which is 100 per cent equities.

“But people who criticize risk parity for that are hindsight buyers who only now realise what a great market we had pre- 2008.”

Lee said he liked the risk parity approach because it took account of risk over time and managed “the risk regret.” Neuberger Berman advocated a three year investment horizon to its clients.

“No investor will say that they are anything but long term, but we don’t believe that anything more than three years is effective, because according to our research after three years the benefits from diversification begin to decline,” he says.

“So we see that if you hold anything beyond three years the additional benefits will be very small, so risk parity requires some dynamic balancing over time, with assets moving in an out of what are often very liquid portfolios.”

Lee acknowledged that risk parity was an effective strategy for investors “with no conviction” on the market direction.

Because risk is allocated equally across asset classes, he sees the approach as “a very good starting point” to investors, who may then change their portfolios as their convictions develop.

“Only when you have a very high conviction on the market direction might you want to deviate from risk parity,” he says.

“But to do that, I always recommend that clients go back to the basic rule, of knowing their universe and understanding their investment goals.”

The €2.3-billion ($3-billion) assets at the Volkswagen charitable foundation in Germany are powered by portfolio theory and diversification.

The foundation is so keen on modern portfolio theory that its founder Harry Markowitz gets a mention in its annual report.

Chief investment officer Dieter Lehmann says he is sure “that his correlation analysis isn’t correct at each point in time, but as an average it is correct.”

The foundation, which despite its name has no affiliation with the modern-day Volkswagen company, being formed from the proceeds of a privatisation of the firm in the 19050s, has tried to implement a wide diversification of its assets to adhere to these principals.

It is most evident in the geographic spread of the foundation’s assets.

A mere 15.3 per cent of its $740-million equity holdings are invested in Germany – a proportion outstripped by its investment in both South East Asian and US equities.

A similar story is true in bonds, with a modest 29.4 per cent of its approximately $1.9-billion debt portfolio tied up in domestic government issues.

Some 57 per cent of its $556-million real estate portfolio is held in German properties – another modest proportion in an asset class where investing at home is usually much less complex.

 

Emerging market interest

The foundation made $211 million from its asset management in 2011 – by all accounts a good return in a turbulent year for investors.

Its penchant for diversification is starting to take it into emerging market bonds, with a recent $91-million allocation to the asset category.

Lehmann says that the foundation’s response to the eurozone crisis has naturally been to gain more foreign currency assets. These have been hiked from a long-term average of between 12 and 19 per cent to above 30 per cent.

Four per cent of total assets are now held in Australian dollar-denominated bonds, with additional Norwegian krone debt also recently acquired.

 

Navigating foundation law

Acquiring foreign-currency holdings is currently a necessary inconvenience for the foundation.

This inconvenience arises from Lehmann’s admission that the foundation prefers to manage assets in house, but all foreign currency holdings are mandated to external managers.

Germany’s foundation regulations, which Lehmann terms “special”, provide strict restrictions on any ‘commercial income’ derived from asset management.

The net result of this is that it is easier, and cheaper in Lehmann’s opinion, to run passive in-house portfolios.

Passive management also suits portfolio theory better, he adds, “so you aren’t investing in assets that will later change and ruin your correlation analysis”.

The Volkswagen Stiftung’s bond holdings are run passively to match certain sub-sets of figures from indices, rather than match any one index – an approach it labels ‘semi-active’.

That allows a tie to indices but creates added flexibility.

The bond holdings are invariably held to maturity due to another important condition in foundation law.

Only ‘ordinary income’ – bond interest, dividends or tenant income – can be used for grant making.

Profits from asset sales, on the other hand, have to go onto the capital sheet. That is not to say these returns are neglected, as maintaining the real value of the foundation’s capital is an important objective.

 

Finding the components

The search for ordinary income has an impact on which asset classes that the Volkswagen Stiftung can use.

Investing in private equity, for instance, carries a risk that regulators might scrap its charitable tax status as this would draw commercial income.

Hedge funds is another thorny asset class for the same reasons.

The foundation asked its local fiscal office in 2005 for permission to invest in hedge funds and private equity, with the foundation having identified their use as boosting diversification.

The fiscal office was sympathetic and it was granted permission to invest a maximum of 10 per cent in alternatives.

Three different fund-of-fund managers could not provide the returns that the foundation was looking for in a hedge fund portfolio, however, and the holdings were scrapped in 2010.

Private equity holdings have been less disappointing but Lehmann says the foundation has no desire to increase the 3.5 per cent stake in this category.

Matching the kind of private equity investments commonplace for US foundations would in anyway be “impossible” for a German foundation in any case, Lehmann says.

 

Property

A definite goal of the foundation is to reallocate the real estate portfolio towards a greater exposure to European office properties.

Given that over 15 per cent of the real estate portfolio is invested in Holland, over 10 per cent in France, and 5 per cent in Belgium, the customary geographic diversification is evident here.

The current real estate portfolio ties in neatly with the foundation’s charitable interests.

Scientific institutions let two of its key office holdings, in both London and Washington.

Likewise, an eye-grabbing investment in a historic palace in the foundation’s home city of Hannover is set to tie the grant making side of the business to the investment income.

Conferences, workshops and summer schools that the foundation sponsors might be held in the conference center of the reconstructed Schloss Herrenhausen.

The palace was destroyed in a 1943 air raid. Lehmann says the Volkswagen Stiftung can bank four per cent annual returns by financing the rebuilding project.

Publicity for the foundation from conference delegates and the public visits to the palace museum is also a way to profit from this unique investment.

Many of the countries with the largest oil reserves also boast the largest sovereign wealth funds (SWFs). And yet African producers, like newcomer Ghana, Angola, and Nigeria which has been pumping oil since the 1950s, haven’t saved much of their oil revenue. Now, in an effort to replicate the long-term growth of funds like Norway’s $600 billion Government Pension Fund accrued from North Sea riches, and the Abu Dhabi Investment Authority with assets somewhere around $900 billion, all of these African countries are in the process of launching their own SWFs.

Many of the countries with the largest oil reserves also boast the largest sovereign wealth funds (SWFs). And yet African producers, like newcomer Ghana, Angola, and Nigeria which has been pumping oil since the 1950s, haven’t saved much of their oil revenue. Now, in an effort to replicate the long-term growth of funds like Norway’s $600 billion Government Pension Fund accrued from North Sea riches, and the Abu Dhabi Investment Authority with assets somewhere around $900 billion, all of these African countries are in the process of launching their own SWFs.

In Nigeria the government has pledged $1 billion in seed funding to a SWF, promising an additional $1 billion a year targeting $6 billion by 2017. Optimistic forecasters say that one day the fund could top $250 billion.

Last month Angola launched Fundo Soberano de Angola (FSDEA) starting with $5 billion in assets, and Ghana is also planning to save a small proportion of its oil earnings. A law passed last year that allows the government to use 70 per cent of oil revenues to fund its budget and save 30 per cent in heritage and stabilisation funds.

Nigeria’s fund is divided into a future generations fund, a stabilisation fund and an infrastructure fund, each representing at least 20 per cent of the total. Former investment banker 42-year old Uche Orji, who worked at JP Morgan, Goldman Sachs and most recently UBS in New York, has been appointed chief executive after a year-long search run by consultancy KPMG.

Offshore and alternatives focus

No decisions have been made on how the fund will invest but like other wealth funds, Nigeria’s is likely to invest offshore to remove liquidity and inflationary pressure from the domestic economy. Investment strategy will likely focus on global fixed income and equity, aping SWF strategies of other oil producers, especially Norway where the current asset allocation is a highly traditional mix of 60 per cent in global shares, about 40 per cent in bonds and a tiny percentage in property. The stabilisation fund will hold more liquid assets.

Some commentators expect an emerging markets bias. Research from consultancy Monitor Group shows the Asia-Pacific region attracted the largest chunk of SWF direct investments in 2010 at $25.2 billion – nearly half of the total.

Nigeria’s central bank governor Lamido Sanusi recently shifted 10 per cent of the country’s $33 billion foreign exchange reserves into remnimbi saying there was “less appetite” for holding dollars. Some predict Nigeria’s fund may also come under pressure to help lift asset prices on the Nigerian Stock Exchange investing in equities as well as federal and state government bonds.

The SWF should resist such pressure,” warns Ayo Salami at London-based alternative asset manager Duet Management.

In line with the growing trend of Africans investing in their own continent, strategy at Africa’s new SWFs could also have an African bias. Algeria and Libya could be models to follow, suggests Sebastian Spio-Garbrah at DaminaAdvisors in New York. Libya’s secretive fund – it scored a transparency rating of two on the SWF Institute’s Linaburg-Maduell Transparency Index – has between $50-$70 billion of assets under management and had stakes in big European firms like UniCredit, Italy’s biggest bank, but was also invested in hotels, banking and telecoms groups across Africa.

Investing at home is a strategy Angola’s SWF has already identified. It says it will invest in a wide range of asset classes, internationally but also in Africa targeting particularly “infrastructure investments and investments in specific industries which are likely to exhibit strong growth in Sub-Saharan Africa.”

Here the emphasis will be on sectors like Angola’s undersupplied hotel market. Executives at the Angolan fund also stress they are hunting social and financial returns, backing national strategies for growth that make it more sovereign development fund than pure SWF.

“We are committed to promoting social and economic development, investing in projects that create opportunities that will positively impact the lives of all Angolans today and to generate wealth for future generations,” says José Filomeno de Sousa dos Santos, an executive on the fund’s board.

Nigerians believe their fund may also have ambitious alternative allocations. In an investment model already proven by the African Finance Corporation (AFC), a Lagos-based development financier set up in 2007, Nigeria’s SWF may prioritise infrastructure and resource plays.

“The Central Bank of Nigeria provided the Africa Finance Corporation with $1 billion to invest back in 2007. The current set up at the SWF reminds me more of the AFC than a typical SWF,” says Samir Gadio, emerging market strategist at Standard Bank. AFC strategies have included undersea cables linking Europe and West Africa, South African technology groups and Ghana’s Jubilee oil field.

 

Inhouse strategy, outsourced investment management

It’s thought that Nigeria’s fund will run investment strategy in-house but use foreign managers.

“Expect the usual suspect – the big guys in New York – UBS, Goldmans, Mellon,” said Bismark Rewane, chief executive of Lagos-based Financial Derivatives Group.

One hope is that new sovereign funds will encourage Africa’s own asset management industry too. Opportunity to manage the money may be used as a carrot to draw more of the big investment banks to the region.

“I don’t think there are enough Nigerian managers to offer the fund sufficient opportunities to invest with Nigerian managers,” says Salami adding: “although the pressure to allocate the majority of funds to Nigerian managers will be substantial.”

For all the fanfare, Nigeria’s SWF has had a challenging start that doesn’t bode well for the future. Nigeria’s 36 powerful state governors, who under the country’s federal system receive a share of national oil revenue, have hindered progress since money portioned to the SWF means less for their states. For now they have insisted the SWF be managed separately from Nigeria’s other oil savings, the $9.6 billion Excess Crude Account, although the idea is that these funds are ultimately pooled.

“There is a big argument between the federal government and the governors,” says Gary van Staden at NKC Independent Economists in South Africa. “They want to know how they get their share of the pot if it all goes into the SWF and they won’t decide investment strategy until this is sorted out.”

The danger is that the waters will get muddier ahead of the next election in three years time. “The governors will say what they want and there will be a political trade-off somewhere, but as we get closer to the election the trade-off will become more in their favour,” warns Rewane.

It is still early days at Africa’s new SWF. But while developed economies battle sovereign debt Africa is planning how to manage its sovereign wealth.

“There is finally a fundamental change afoot in how these countries manage their oil wealth,” says van Staden.

African sovereign wealth funds

Source: SWF Institute

From a risk management perspective, tail risks and return distribution asymmetries of investments are important to analyse. Norges Bank Investment Management (NBIM) in this note describes a modelling approach that addresses some of the weaknesses of standard risk models.

It uses the model internally as a complement to standard models to evaluate tail risk in foreign-exchange (FX) positions. Examples of tail events for FX positions could be single-currency devaluations or more widespread flight-to-quality/carry-trade-unwind episodes.

To access the reseach click below

Modelling the implied tail risk of foreign exchange positions

 

The head of infrastructure at Australia’s $80 billion Future Fund has cited regulatory risk in Europe and the United Kingdom as reasons to be wary about infrastructure investment in the region.

Raphael Arndt, the Future Fund’s head of infrastructure and timberlands, told a Sydney conference this week that he was particularly concerned with the situation in the UK water industry, where industry regulator Ofwat was proposing modifications to licences which would allow for changes in pricing controls.

“We have been attracted to the water industry in the UK because of its outstanding history of regulation, and we have been prepared to fund a share of the billions of pounds of investment the sector needs,” Arndt told the Association of Superannuation Funds of Australia (ASFA) conference in Sydney.

“But we are very concerned about Oftwat’s approach, and think it is hard to understand why they would take that approach rather than working with the industry on an agreed path to any changes.”

Arndt said he hoped the UK Government would “move swiftly and categorically to correct the position.”

“The Government should reinforce the water industry’s standing as a destination for foreign infrastructure investment,” he said.

The Future Fund has $4.7 billion or 5.9 per cent of its assets in infrastructure, an allocation it has built up over the past five years. $2 billion of that is invested in Australia, and around $1 billion in the UK, largely in transport assets such as Gatwick Airport.

“Unfortunately there have been a number of issues in the UK which have given us cause for concern, or at least reasons to pause for thought,” said Arndt.

“For example we have had the imposition of the largest air passenger tax in the world, without any consultation with the industry whatsoever.

“The unclear policies around airport development in the south of England makes it very difficult to investment further capital at this time.”

Arndt was speaking at an ASFA forum on infrastructure investment which was also addressed by the British high commissioner to Australia, Paul Madden.

The high commissioner said the UK welcomed infrastructure investment from Australian institutional investors, and said the December release of the PFI review would chart a clear way forward for the sector.

The UK, he said, had a pipeline of 500 public and private infrastructure projects worth over £ 250 billion.

In a bid to draw more investment from pension funds, the UK Government will launch its new Pension Infrastructure Platform (PIP) will launch as a fund in January 2013, targeting £2 billion ($3.24 billion) worth of projects with the backing of around 10 UK pension funds. Madden said 750 million pounds had so far been committed.

The drive is being led by a trio comprising the UK Treasury, the £11-billion Pension Protection Fund (PPF), protector of 12 million members paying out on schemes employers fail to meet, and the National Association of Pension Funds (NAPF), which counts 1200 pension funds as members, with a combined $1.295 trillion in assets.

 

This research paper by MSCI defines macro-economic risk as the change in asset value due to persistent shocks to real economic growth. This definition underscores the role of long horizons in macroeconomic risk and the principal issue facing investors: how should asset allocation respond to large macroeconomic shocks, given that their consequences are likely to be resolved over long time periods? VIEW THIS PAPER