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3 Reasons to Rethink Risk Parity

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Seeking to justly capitalize on Modern Portfolio Theory (MPT), risk parity uses the power of leverage to form a diversified portfolio that can generate equity-like returns with using less risk than equities. This alchemist-like strategy aims to construct a well-diversified portfolio that has the highest probability of outperforming cash. At formation, a risk parity portfolio has a low expected risk and return profile; however, investors can apply leverage to achieve the desired risk profile. Interestingly, risk parity breaks norms in not using asset class return forecasts to build a portfolio; it uses risk estimates to size positions within the portfolio. Sounds good?

Risk parity has attracted many adopters on the institutional investor side. Some asset owner converts include Denmark’s ATP, Ontario Teachers’ Pension Plan (OTPP), Healthcare of Ontario Pension Plan, Indiana Public Retirement System, State of Wisconsin Investment Board (SWIB) and the Teacher Retirement System of Texas (TRS). In October 2012, TRS invested US$ 584 million in risk parity strategies, awarding it to two external managers, Bridgewater Associates and AQR Capital Management. The Texas pension giant and SWIB developed their own internal risk parity strategy. Some institutional investors find it harder to use external money managers for risk parity due to overlay and control issues.

With that being said, a lot of money managers have been getting into the risk parity business. Some of the heavyweights in risk parity are AQR, Invesco and Bridgewater Associates.

In the last twelve months, risk parity strategies have performed poorly. UK-based investment consulting firm Redington said risk parity lost 5.4% for the year ending June 30th, while U.S. equities and other developed equity markets had positive returns.

Here are 3 reasons why risk parity could be dangerous for an institutional portfolio.

#1.) Massively Underperform in Periods of Rising Interest Rates
How risky are bonds in a prolonged period of zero interest rate policy? Typical risk parity strategies have allocations to nominal bonds which can expect to be pummeled on if interest rates rise faster than expected. In May 2013, the month of the “taper talk”, many risk parity strategies underperformed, seeing fund returns plummet in mid-single digits in a matter of weeks. The interest rate shock of 2013, exposed the sensitivity of risk parity strategies. Ray Dalio’s Bridgewater, known as the godfather of risk parity, had a tough June 2015 month. Bridgewater’s All Weather fund returned -3.78% in the month according to Forbes. Invesco Balanced-Risk Allocation Fund, looking at net asset value, from June 30th, till the beginning of the year netted 0.35%. MSCI World Index posted 2.95% comparing the same period.

Risk Parity Funds and Strategies 2014 Return S&P 500 Price Return USD Excess Return
Bridgewater All Weather Strategy 8.6% 13.69% -5.09%
AQR Global Risk Premium Fund 9.4% 13.69% -4.29%
Invesco Balanced-Risk Allocation Fund 5.5% 13.69% -8.19%
Salient Risk Parity Fund 13.58% 13.69% -0.11%
Putnam Dynamic Risk Allocation 2.69% 13.69% -11.00%

Source: Morningstar, Forbes, Invesco, AQR
 

#2.) When All Asset Values Drop, You Are Still Screwed
Risk parity assumes risk and volatility are related. Like in 2013, when many asset classes fell, the diversified approach failed, leaving nowhere to hide but in cash. Risk parity strategies are short cash, leading to poor performance when cash is king. When markets lose confidence like in 2008, where there was a flight to quality, risk parity would have performed negatively.

#3.) Using Leverage to Reduce Risk
This notion of using leverage to reduce risk makes sense in some scenarios. However, there needs to be sufficient cash in the portfolio to meet margin calls, proper counterparty risk control, true diversification and having a level of asset liquidity. These sophisticated techniques come at a price. Institutional investors when externally allocating are paying big for the modeling and strategic diversification. Varied manager statistical models will yield different answers, thus some managers are able to draw in more clients due to their ability to generate higher returns due to more accurate models.

SWFI First Read, May 25, 2018

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MedInvestGroup Pushes Investment into Russian High-Tech Oncology Centers

The Russian Direct Investment Fund (RDIF) and Mubadala Investment Company have attracted MedInvestGroup, which manages a network of the PET Technology regional oncology and radiological centers, as a strategic investor in the joint management and development of a network of cancer diagnosis and treatment centers. The deal aims to significantly improve the efficiency of the already functional centers in Podolsk and Balashikha. The corresponding agreement was announced today at the St. Petersburg International Economic Forum.

Southern Satellite City and RDIF Reach a Financing Agreement

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French Industrial Giants Find Opportunity with RDIF

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A number of French industrial companies continue to invest within Russia, finding opportunities within the mega country. [ Content protected for Sovereign Wealth Fund Institute Standard subscribers only. Please subscribe to view content. ]

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CPPIB Targets 33% in Emerging Markets by 2025

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The Canada Pension Plan Investment Board (CPPIB) generated a net return after expenses and pension contributions of 11.6% for the fiscal year ended March 31, 2018, versus its reference portfolio of 9.8%. For the reported fiscal year, CPPIB grew its net assets to a new high of C$ 356.1 billion (US$ 277.2 billion), compared to C$ 316.7 from the year previous.

Mark Machin, President and Chief Executive Officer at CPPIB, attributed the performance to the rising tide in public equity markets across most geographies, whose volatility in recent months was buoyed by significant fourth quarter earnings in the fund’s private holdings. Public and private equities, CPPIB’s first and third largest asset classes by exposure at 38.8% and 20.3%, saw estimated returns of 11.4% and 16.1%, respectively. Machin joined CPPIB in 2012 and was moved to the top in June 2016, following the departure of Mark Wiseman. Machin has a knack for the Asian region, being CPPIB’s first president for Asia and also spent nearly 20 years in Asia, working at Goldman Sachs. CPPIB plans to continue heavily investing in the APAC region, along with India.

Emerging Markets

“By 2025, we will invest up to a third of the Fund in emerging markets, which by that time are anticipated to account for 47% of global GDP,” said Machin in his section of the annual report outlining the pension’s updated strategic plan. CPPIB currently has C$ 56.1 billion invested in emerging markets, C$ 22.4 billion of which is wrapped up in China.

Foreign and emerging markets continued to dominate in CPPIB’s private equity investments with returns of 16.0% and 19.5%, compared to 1.8% for their Canadian counterparts. Asia was a standout market for the pensioner, which raised its exposure to private equity deals in the region by nearly 28% from C$ 13.4 billion to 17.1 billion, closed six direct investments worth C$ 1.6 billion, committed C$ 1.7 billion towards eight funds, and completed three secondary transactions for C$ 400 million.

With 275 global transactions completed over the fiscal year, CPPIB’s geographic exposure places 15.1% of its assets at home in Canada, 37.9% in the neighboring United States, 13.2% in continental Europe, 5.6% in the United Kingdom, 3.1% in Australia, and a whopping 20.4% in Asia.

Public Equities

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