A risk parity approach to asset allocation is flavour of the month, in spite, and because, of the leverage it requires, say Greg Allen, president and director of research at Callan Associates, and Steve Foresti, managing director at Wilshire Associates. The public castigation that the State of Wisconsin Investment Board [SWIB] received following its decision to use leverage in its new strategic investment direction, is testament to the philosophical leap required by pension boards in considering a risk-parity approach to asset allocation. On the surface, the theory makes sense: reduce the traditional allocation to equities so that diversification endures via a more equally-weighted allocation, and use leverage to increase the return.

A number of asset managers have been touting this approach to a global diversified multi-asset class portfolio – groups such as Bridgewater, BlackRock, Putnam, AQR and PanAgora, whose chief investment officer, Edward Qian first coined the term in 2005. But now, as a reaction to the mean-variance-optimisation framework resulting in underdiversified portfolios that failed to provide risk control when it was needed, public sector funds and their consultants are exploring the approach as a potential asset allocation alternative. While the theory makes sense, Greg Allen, president and director of research at Callan Associates, says there are many considerations that funds will need to overcome in exploring this approach. The philosophical hurdles include overcoming the predisposition to favour equities and introducing leverage at the policy level. “In the US there is nothing worse than being different and wrong at the same time,” he says.

“And the return pattern of this approach is completely different which is aggravated by using leverage.” In addition Allen says leverage is “still a dirty word” – despite its acceptance in strategies, it is rarely so explicit. The SWIB discovered this out when announcing the 2010 asset allocation strategy, which had been considered for some years: this included shifting its allocation out of equities into fixed income and adding leverage. [Ohio Fire and Police have also recently approved this strategy.] For the SWIB the allocation to equities comprised about half the core fund’s assets but 90 per cent of the total fund volatility, so the rationale was to trade a reduction in the allocation to stocks for the lower risk of fixed-income. In the US, the media put pressure on the SWIB accusing it of gambling with taxpayers’ money. But according to consultants such as Callan’s Allen, the approach can represent a potentially liquid, transparent, low-fee alternative to a hedge fund exposure. A Callan Investments Institute research paper contrasts the methodology of this approach with the traditional meanvariance approach in the context of developing policy portfolios for large institutional investors.

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