Its analysis determines that in the 20-year period since 1990, a levered risk-parity portfolio that delivered an 8.25 per cent return would have done so with about half the volatility of an unlevered efficient-frontier portfolio. But, to produce an expected return of 8.25 per cent, the paper says that a levered risk parity portfolio employing standard asset classes would require somewhere between 40 and 60 per cent leverage, depending on the expected returns for the unlevered portfolio and the cost of borrowing. This puts a whole raft of operational considerations on the table. “One of the most important considerations is that you have to be good at borrowing,” Allen says. “This is a skill that is very specialised.” In addition he says funds can add value by making global asset allocation decisions along the way, and most fund sponsors are not set up for that either.
Wilshire Associates’ paper on the matter, “Risk-focused Diversification”, also highlights that operational considerations become more of a focus under this approach and include incremental management costs and in particular leverage costs, which are variable under periods of market stress. “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 riskfocused 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 cashflow, liquidity and operational-type risks are paramount. “Risk management becomes a heightened focus and few institutions are equipped to handle it in-house,” he says. 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.