A Flexible Approach for Managing Risk
By Khaoula Begdouri, CFA, CAIA
Many large defined contribution plans are seeking to improve the retirement outcome of participants by importing time-tested DB strategies into a DC framework. One approach previously unique to more sophisticated investors that is now prompting more interest in the DC world is risk parity.
In its simplest form, a risk parity strategy spreads risk equally between asset classes so that each contributes the same amount of volatility to the portfolio. Traditional diversification methods focus on the capital allocation. Even if the result is a balanced dollar allocation to equity and non-equity assets, the dominant source of volatility is typically heavily skewed towards equity risk.
Risk parity strategies seek to overcome this bias by achieving a broader and more balanced exposure to all priced risk factors. Exposures to such factors as equity, real rate, inflation, political and liquidity risk are identified within each asset class so that they can be mapped into an optimized portfolio with a balanced risk budget.
The resulting portfolio typically has less capital in equities and more in less volatile asset classes such as fixed income. However, the use of capital efficient instruments seeks to ensure that proper diversification is maintained without sacrificing returns. The objective is a portfolio that captures diversified risk premia and thus offers a more stable risk and return profile across various market environments.
Advocates and Critics
Some of the strongest proponents of risk parity believe it to be an important strategy against market turbulence. More moderate advocates see it as viable route to alleviate some equity risk without necessarily giving up growth. Critics, however, caution against its substantial investment in fixed incomes and its use of leverage. But even investors who believe in the merits of risk parity approaches struggle with how to fit it in their investment policy without a secular shift from their traditional allocation.
We don't believe the traditional and risk parity approaches need to be mutually exclusive. We believe a dual methodology approach can provide plan sponsors and consultants with a creative and flexible framework that reaps the benefits of risk diversification without a deviation from the traditional approach.
In particular, we have analyzed how to include a risk parity strategy within a custom target date fund glidepath. We have found that by recalibrating part of the growth assets, target date funds can achieve returns that are driven by broader sources of risk for a better risk adjusted return profile and a stronger resiliency to market downturns.
Using a Dual Methodology Approach
This article will offer a quick overview. We use the BlackRock collective target date funds allocations for analytical and illustrative purposes, although the framework is applicable to any target date family and/or glidepath. We use BlackRock's optimal beta strategy as the risk balanced portfolio.
The challenge is optimizing the risk balanced portfolio's own set of beliefs regarding risk and return alongside the legacy traditional optimality. We accomplish this through what we refer to as the dual methodology approach. There are three important considerations.
The first is defining the objective. We believe that DC participants favor stability of outcomes. With that in mind, we define the objective as getting the benefit of a more balanced risk factor exposure with improvement of the risk/return profile across the glidepath while maintaining cost efficiencies.
Next we need to separately analyze the risk factor exposure in both the target date fund and the balanced risk portfolio. (Risk factor exposures measure the exposure to a risk premium that's expected to be rewarded. For example, inflation risk exposure is an active bet to take on the inflation risk and capture the associated premium.) We create a mapping matrix for all the target date vintages across the glidepath, comparing risk factor exposures against the risk balanced portfolio.
The final consideration is the dual optimization process. The risk balanced portfolio seeks to deliver returns that are comparable to the long-term expected returns of developed equities but with lower volatility. By recalibrating a portion of the equity allocation within a custom target date fund to the risk balanced portfolio we should be able maintain growth while curtailing losses in equity down markets. Dual optimization allows us to test various recalibrations to find a better overall mix of risk factor exposures.
Aligning Risk Factor Exposures
The target date fund used in our analysis has an equity landing point of 38%. Using that as our starting point, we ran optimizations recalibrating portions of the equity investment into the optimal beta strategy until we created a retirement portfolio where the risk exposure factors were most closely aligned with those of the risk balanced portfolio.
Ultimately, we shifted 53% of the equity allocation, or 20% of the overall fund, into the balanced risk portfolio. (It should be noted that the weighting would vary for other target date funds.) This 20% allocation is anchored and optimized at the retirement portfolio and can be maintained throughout the entire glidepath to represent a static allocation. Therefore, as the funds age and the growth asset percentage decreases, the risk balanced portfolio becomes a larger portion of the overall growth allocation, increasing the potential stability while positioned to capture the growth necessary to fund 30 years of retirement spending.