It’s your move: Rethinking risk

Changeable markets over the past decade have made pension plan sponsors rethink their approach to risk

Little has changed in modern portfolio views over the last few decades. Many institutional money managers and plan sponsors have been working with the simple strategy of splitting their investments and exposures between equities and fixed income. More often than not, this results in a 60/40 weighting of equities and bonds, respectively, with the idea that this amount of diversification will weather volatile markets and produce suitable returns.

But much has happened over the last decade to change that mindset. A tech bubble in the early 2000s, a serious financial crisis in 2008 and a bear stock market in 2011 have led investors to search for strategies that look beyond simple allocations. The risk associated with investments, the markets and the economic environment is now taking hold of investors’ imaginations and changing the way portfolios are managed.

New Views on Risk
Risk factor investing seeks to identify all of the unique risk factors that affect different asset classes and isolate those factors to use them as building blocks in a portfolio. This type of approach takes into account much more than just the investment; it looks to maintain consistent returns while also limiting downside risk.

According to Vincent de Martel, managing director in the multi-asset strategies group with BlackRock, this strategy is made up of two components. The first is to invest in “risk terms” as opposed to “capital terms.” “When you look at a portfolio and you look at the capital allocation, this is not a good reflection or description of what your experience as an investor might be,” he says, explaining that even a so-called perfectly balanced portfolio of equal equities and fixed income will be imbalanced. “What will drive the success or the failure of the portfolio, compared to your expectations, is going to be how well equities do.” And about 70% of the risk will be concentrated in the equity portion of a balanced portfolio, he adds.

As a result, says de Martel, investors need to recognize that what appears to be diversification on the surface can be misleading. Investors must look at the reality of diversification and the amount of risk that goes with it. “This is a sea change for investors,” he explains. “Investors have been used to looking at their portfolio and how they spend their dollars but not really thinking about whether the asset classes they invest in are equivalent from a risk perspective. They are not equivalent.”

The second component of risk factor investing is to look at the portfolio in terms of risk factors rather than different asset classes. There are only a few microeconomic factors or sources that can explain the return within these asset classes, notes de Martel, including interest rates, credit, liquidity and emerging markets. “Instead of considering your portfolio from an asset class perspective, you need to look at how much you need to allocate to these different sources of return—these fundamental drivers.” The objective, he explains, is to create a portfolio with the true underlying components of return built into it.

Risk Parity
One subset of risk factor-based investing is risk parity, an allocation method that adjusts all investments to provide the same amount of risk. Michael McHugh, a client portfolio manager with Invesco, explains that “the end goal is the same: to produce truly diversified portfolios that can better weather regime shifts across the economic cycle than more traditional forms of asset allocation that tend to be dominated by equity or equity-like risk.” What’s different, he adds, “is the execution of that goal.” Risk factor investing may incorporate alternatives, for example, to diversify a portfolio and help investors to manage risks, while risk parity strives to equalize the risk contribution of each asset class in the portfolio.

As macro investors, McHugh explains, investment managers spend a lot of time understanding how different asset classes behave across various phases of the economic cycle and relative to one another. “What we are looking for is assets that correspond well with different phases of the cycle while providing meaningfully differentiated behaviour from one another. Asset classes can be thought of as collections of different risk factors that influence the risk/return characteristics of each asset class.” He stresses that not all asset classes are composed of the same risk factors or may respond in a meaningfully different way to the same risk factor.

Gaining Momentum
For obvious reasons, returns have always been at the forefront of plan sponsors’ minds, and allocations have reflected that mentality. But the last decade and a half has been an eye-opener in terms of strategy. “We’ve had three major crises—2001, 2008, 2011—that changed the mentality where return is desired,” explains Mathieu Tanguay, investment business leader with Mercer. “The focus now is much more on [managing] risk.”

He says plan sponsors had to make larger contributions after those downturns and, as a result, became much more aware of risk. As pension plans become more fully funded and the issue has abated for many of them (at least for now), Tanguay says plan sponsors are not interested in falling into that situation again. Even though there were some pension plans with allocations diverted to alternative investments—such as real estate, infrastructure, hedge funds and other asset classes that allow for better diversification—risk factor investing gained traction after the 2008 crisis, says Tanguay. “So [plans] are trying to diversify. And if there is another 2008 or 2011, hopefully, it won’t hurt as much as it did then.”

McHugh agrees and says that no matter how large the plan sponsor is, the mentality is turning toward how the sponsor can achieve lower levels of volatility but be better off from a return standpoint—something he refers to as “winning by not losing.” McHugh says he has been seeing growth in these types of risk-based investments both in the retail and corporate pension sectors.

Tanguay says the preliminary results of Mercer’s 2013 Asset Allocation Survey show that allocations to alternatives among Canadian pension funds grew to 38% in 2013—up from 25% in 2010. The median allocation for institutional investors that already had an allocation to alternatives grew to 18% in 2013 from 15% in 2010.

The financial crisis also uncovered the reality that processes for analyzing risks and exposures within the strategic asset allocation employed by plan sponsors were not sufficient. For example, risk factors such as exposures to credit, volatility and size or quality of the portfolio were not explicitly tracked, says Greg Nott, chief investment officer with Russell Investments Canada. “If you just look at sector exposures and regional exposures, and not at how large those other risk factors are, then you do not truly have the full picture of what might be the driving risks—and hence the performance—of your portfolios,” he explains. “Plan sponsors’ and investment managers’ systems were not really measuring them, and they weren’t being thought about at the time.”

The Next Move
Nott says a positive side note to this strategy is that many pension plan sponsors are moving away from strict bond and equity portfolios and are seeking to add uncorrelated risk exposures, thus providing for better diversification and, ultimately, creating a more robust asset allocation. Even if they have not fully considered their funded status, or if they are on a de-risking glide path (or an allocation that considers risk), momentum in these types of strategies is building.

According to McHugh, there are three phases of the economic cycle that should be accounted for in a portfolio (which a risk-based portfolio takes into account): non-inflationary growth, unexpected inflation and recession/deflation. As 2008 demonstrated, an average 60/40 portfolio addresses only the non-inflationary cycle.

“What we want to think about is building a portfolio that is more robust and can work through that economic or market cycle,” says Nott. “We want to balance the risk coming from stocks, bonds and commodities.” Over time, he adds—by calculating risks, diversifying and using the right investments that take into account market risk cycles—equity-like returns can be achieved with bond-like risk.

Tanguay agrees and says that investments such as infrastructure and real estate can provide inflation protection. If a pension fund offers indexing, for example, and is therefore exposed to inflation, that feature would be helpful. Similarly, infrastructure and real estate provide a steady income necessary for the payouts and funding of a pension plan.

On the con side, some of these investments are less liquid than typical equity investments. In many infrastructure or real estate investments, money could be tied up for 10 to 15 years, notes Tanguay. Sponsors of closed pension plans need to consider their liquidity constraints when deciding to allocate to alternatives.

Whether they are thinking of risk or preservation of capital, pension plan sponsors are beginning to make the move to a more diverse portfolio. De Martel says risk factor investing is the next frontier in asset allocation, and a lot of investors are ready to convert to this way of thinking. “It will take time, but we are definitely seeing more and more conversations about this topic.”

Joel Kranc is a freelance writer based in Toronto.

Get a PDF of this article.