Which Risk-Parity-Based Pension will Blow up First?
A real basic question: Is risk parity driven by the long-bond?
Another real basic question: Which pension following risk parity will blow up first?
A real basic answer: pension funds levering up US T-Bonds!!!
An intriquing WSJ article on the topic of risk parity:
Some extra special comments:
In Virginia, officials at the Fairfax County Employees’ Retirement System have revamped the entire $3.4bn portfolio around a risk-parity approach. About 90% of the pension’s portfolio now is exposed to bonds, when factoring in leverage. “We think we can improve returns while reducing the risk level of the portfolio,’ said Robert Mears, the pension fund’s executive director.
Risk parity’s growing popularity comes at a fragile time in the bond market. Some critics warn the strategy may fizzle if interest rates rise and erode bond returns. There is “reasonable concern” that could happen once the bull market for bonds cools, said Mark Evans, a managing director at Goldman Sachs Asset Management, a unit of Goldman Sachs Group. That factor “isn’t likely to be there going forward for a number of years.”
The employee pension fund of United Technologies has gradually increased its risk parity-related investments to $1.8bn, or about 8% of its total assets, up from an initial 5% allocation in 2005. At the San Joaquin County Employees’ Retirement Association, in Stockton, California, risk parity now amounts to 10% of the pension’s overall portfolio of approximately $2bn. In an email, the pension fund’s chief investment officer said the fund “is aware of the leverage being utilised in their risk-parity strategies and has no misgivings.”
Some interesting food for thought:
It is well known that pension funds in the United States are underfunded even if they achieve their projected 8% rate of return. The scope of pension underfunding increases to an astonishing level when more probable future rates are employed. A reduction in the future rate of return from 8% to the more reasonable risk-free rate of approximately 4% causes the liabilities to explode by trillions of dollars. As bond yields declined over the past twenty years, pension funds moved toward more aggressive equity-based portfolios in an attempt to reach for this 8% return. By investing in a portfolio with uncertain outcomes, pension funds could experience increasingly volatile and even negative returns. Paradoxically, in an effort to chase the universal 8% rate, pension funds may be laying the groundwork for returns even lower than the risk free rate. In an effort to offer an empirical basis for this possibility, we conclude the paper with a relevant comparison – the return of a hypothetical Japanese pension for the past two decades. We believe that pension funds need to at least prepare for the unfathomable: 0% returns for 20 years. Most pension funds, regrettably, have not adequately stress tested their portfolios for these scenarios.
I actually appreciate the risk parity idea and utilize it in different capacities. However, ALL trading strategies freak me out when everyone and their sister is involved. It is just a matter of time before the “liquidity event” hits the risk parity crowd. Meb has a nice list of the numerous players here.
Note: This site provides NO information on our value investing ETFs or our momentum investing ETFs. Please refer to this site.
Join thousands of other readers and subscribe to our blog.
Please remember that past performance is not an indicator of future results. Please read our full disclosures. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.
Definitions of common statistics used in our analysis are available here (towards the bottom)