Risk parity becomes bittersweet flavour of the month (2)

 

“Understanding a program’s results involves attributing relative performance to active management, identifying any tactical asset allocation decisions and assessing mechanical factors such as leverage costs.

“For most investors implementation of a leveraged strategy would likely require the retention of a beta overlay manager to execute and maintain the desired leveraged systematic exposures or an allocation of capital to one or more of the off-the-shelf investment products which employ embedded leverage to achieve asset class risk balance.”

The managing director and head of research at Wilshire, Steve Foresti, says he views the approach as a “removal of a constraint connected to building a portfolio”.

“The main objective of a risk-focused portfolio is the attempt to maintain diversification at a required rate of return. If you move to the right of the efficient frontier you get more risk for more return but you are sacrificing diversification to get more return.”

This approach attempts to achieve the same level of expected return while maintaining diversification.

“The catch is while you are removing a risk, you are replacing it with other risks,” Foresti says.

When using synthetic exposures through diversification, liquidity issues are very important and need to be well-thought-out: this means cash flow, liquidity and operational-type risks are paramount.

“Risk management becomes a heightened focus and few institutions are equipped to handle it in-house.”

And derivative maintenance issues are a particular consideration in times of extreme market volatility.

Wilshire also notes that the asset class to be increased relative to a traditional portfolio is not necessarily where an investor must have derivative exposure.

Another aspect to consider, highlighted in the Callan paper, is that due to its higher allocations to fixed income, the levered risk parity portfolio will be more sensitive to interest rate movements than an unlevered efficient frontier portfolio with the same expected return.

All these operational risks can potentially be overcome with advances in the monitoring, reporting and risk management tools use by institutional investors.

What may be harder to overcome is the psychological risk of being different, as Callan’s paper highlights.

“One risk that will always remain – by design, the underlying portfolio will have a very different pattern of returns from the portfolio employed by the typical long-term investor. Applying leverage will amplify this difference.

“In periods characterised by rising equity markets, particularly if they are accompanied by flat or inverted yield curves, the levered policies have the potential to underperform peers by thousands of basis points.

“During these periods, fund sponsors who choose to implement this type of approach will need to be able to convince their constituents to maintain a long-term perspective. Ironically that is the same challenge that the proponents of the traditional approach are facing today.”