Defined benefit (DB) plan sponsors face the challenge of generating the required return as well as the need for stability in the plan’s funding status.
In a new paper, PanAgora Asset Management says, “We have long argued that these challenges can be addressed through asset allocation in general, and risk parity in particular.” For those plans unable to invest in risk parity, the paper discusses an alternative strategy to target equity exposure within a pension plan—employing a defensive equity strategy designed to reduce downside exposure to market movements, coupled with risk parity-like portfolio construction techniques—referred to as “defensive equity multi-factor.”
The paper’s authors note that public plan sponsors have rationally increased risk-taking in their policy portfolios to align expected returns with required returns, including reducing exposure to core fixed income in favor of equities and alternative investments while also moving from public markets to private markets. “While these actions indeed increase plan volatility as well as its expected return, they also include the unintended consequences of increasing its sensitivity to growth shocks and reducing the plan’s liquidity,” the paper says. “Unfortunately, a high required return hurdle in a low return environment is not the only challenge plan sponsors are facing. Managing pension liabilities is not an exercise in solely maximizing the terminal value of plan assets. The path to wealth accumulation is now entering a phase where it is more important than ever. As the Baby Boomer generation begins to enter retirement, most public pension plans will begin a net de-accumulation phase. This dynamic puts a premium on the stability of the plan’s funding status and consequently increases the perils of having a high sensitivity to growth shocks.”
Bryan Belton, director, multi asset, at PanAgora Asset Management in Boston, and co-author of the report, says risk parity is more widely used in the public sector, mostly for accounting reasons. With corporate defined benefit plans, there is a huge benefit to using liability-driven investing (LDI) because changes in the funding status go through the income statement. With public plans, pension funding volatility doesn’t necessarily go through the income statement, so they focus on maximizing the Sharpe ratio of investments, he explains.
However, Belton continues, in terms of economics, both public-sector and private-sector DB plan sponsors care about getting a return and the stability of returns. “Our view is risk parity can do that, and for those that can’t embrace risk parity, owning cyclical assets like equities more defensively than a cap-weighted approach would promote stability in plan funded status,” he says.
Belton notes that most defined benefit plans invest in three sources of returns: equities, fixed income—including high-grade bonds and credit—and inflation-protected assets. He notes that the goal of risk parity is not to diversify just the amounts invested, but how the investments contribute to risk. Risk parity portfolios have an equal risk weight instead of an equal dollar weight; e.g., if stocks have a volatility of 15% and fixed income has a volatility of 5%, a risk parity portfolio will own three times more fixed-income investments than equity. In this example, a risk parity portfolio would achieve balanced risk contribution between stocks and bonds by investing 25% of its capital in equity and the remaining 75% in fixed income. According to Belton, this unlevered risk parity portfolio is balanced but may produce low returns.
To mitigate this, most risk parity managers apply leverage to this risk-balanced portfolio to target higher returns. Belton explains this by comparing it to buying a home. “Leverage is created when the cumulative investment exposure exceeds the amount of capital. The most common use of leverage is in homeownership. A person buys a $300,000 home with only $60,000—i.e., 20% down—and the remaining $240,000 is raised via a mortgage. The new homeowner has levered $60,000 to make a $300,000 investment. This is considered five-times levered. Leverage amplifies the magnitude of returns. If, after a year, the homeowner sells the home for $330,000, the house increased in value by 10%, but the homeowner made a 50% return because he made $30,000 on an initial investment of $60,000.
“With risk parity,” he continues, “if bonds return 2% over cash and stocks return 6% over cash, a 25/75 portfolio will return only 3% over cash. To mitigate the problem of a lower than required return, leverage can be applied to a 25% equity/75% bond portfolio to amplify the return. Levering this portfolio two times would increase the investment exposure to 50% equity and 150% bonds. It would also double the expected return from 3% to 6%. One important distinction is that mortgages represent borrowed leverage. Risk parity portfolios use instrument leverage through derivatives—typically exchange-traded futures,” Belton says.
Futures contracts are standardized agreements that typically trade on an exchange. One party to the contract agrees to buy a given quantity of securities or a commodity, and take delivery on a certain date. The other party agrees to provide it. Some investors seek to make money off of price changes in the contract itself, trading it merely to buy or sell it to others. If the price of the securities or commodity rises, the futures contract itself becomes more valuable, and the owner of that contract could sell it for more to someone else.Leverage aversion is one reason some plans can’t embrace risk parity, Belton says. He adds that some plan sponsors worry about peer risk—that if their portfolio is much different from peers’, they may be outliers. For others, it may be they just don’t understand what risk parity means.
An alternative to risk parity
Nick Alonso, also a director PanAgora Asset Management’s multi asset group in Boston, and report co-author, explains that a defensive equity multi-factor strategy is a long-only equity portfolio that replaces a traditional cap-weighted index, balancing risk across sectors, countries and individual stocks. What makes it a multi-factor strategy is that, instead of investing in all stocks in the universe, it invests in stocks that have the highest exposures to quality, value and momentum factors. “The line of reasoning is [that] selecting stocks with high factor exposures increases return expectations while balancing risk and helps protect the portfolio when economic conditions are not positive,” Alonso says.
He adds that, in the paper, the authors model a scenario where plan sponsors replace their equity allocation with the defensive equity multi-factor strategy. They maintain the same equity allocation, but defensive equity has a higher weight in defensive sectors, such as consumer staples, utilities and health care and a lower weight in growth sectors such as finance or technology. Also, there is not as much weight in large-cap countries such as the U.K., but more in mid-cap countries. And, instead of having so much weight in large company stocks, capital is more allocated to the mid-cap segment of equities.
“In our view, the right way to think about public plans owning stocks and bonds is to make them all matter similarly,” Belton says. “If 75% of portfolio risk is coming from equities, and a plan sponsor can’t get away from that, it should try to make an effort to own equities in the best way. A cap-weighted strategy skews its weight toward the largest stocks, but if plan sponsors own equities in a much more balanced way, it will help with stability. Replacing cap-weighted equity with defensive equity may not be as good as risk parity, but it is a step in the right direction.”
The paper, “Improving Asset Allocation Using Defensive Equity,” may be downloaded from here.
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