(Pictured: Nick Bullman)
by Greg Bright
At the annual Portfolio Construction Forum last week, which took the 500 attendees on an entertaining journey through the past 100-or-so years, including the evolution of investment theory and practice, the audience warmed to the importance of risk.
By the end of the event, during which they were peppered with presentations about the management of risk, they had adjusted upwards their views of its importance, with about two-thirds saying it was the most important factor to consider when building a portfolio, compared with less than half at the start of the conference. At least one consultant and strategist, however, did not believe them.
Tim Farrelly, principal of Farrelly’s Investment Strategy, questioned whether advisors actually did pay such credence to risk. “With all the investment committees and practices that we work with, whenever we suggest a new strategy or product, the first two things they ask are: ‘what will it do for returns and how much will it cost?’,” he said.
This is an important thing to question. What Farrelly is saying is that advisors, and probably the rest of us in the investment community, are struggling to transition their thinking away from a returns focus. Risk is embedded within the thought process rather than the subject of special attention. This is despite all the talk of the looming retirement incomes problem due to demographics and the worldwide search for yield in investing due to low interest rates.
Perhaps it may be easier to bring risk to the forefront, overcoming this mental or behavioural impediment, if advisors think about how shifting allocations according to their perceived riskiness increases portfolio returns.
Nick Bullman, founder of UK-based Check-Risk, gave the best possible example of how this works. He told the conference that his firm had been working with a UK financial services firm, IFG, on a new suite of funds which have been built to optimize their payback from each unit of risk being taken. IFG has seeded the four funds with 150 million euro for their launch next month.
Bullman said that investing for risk did not over weight any one style but, rather, blended them. Tests with the funds over the past few months, with dynamic asset allocation adjustments according to risk, showed both higher returns and lower volatility, although the aim over long periods was to produce similar returns with less volatility.
Bullman likened a returns focus by investors to “target fixation”, which is a phenomenon which was noticed by aviators and studied between the world wars. It was noted that many pilots had a tendency to follow down the target planes they were shooting at and, even, crashing into them.
Check-Risk uses about 170 different risk factors in its model, including premia such as value versus growth, momentum, illiquidity, credit risk and volatility.
Bullman said there were six main components to investing for risk: asset allocation, fundamentals, cyclicality, sentiment, momentum and risk management.
Asset allocation needed to correspond to the investor’s style, such as lifestyle funds. Fundamentals were the usual valuations and forward-looking earnings multiples. Cyclicality addressed the question as to whether you were taking a risk at the right point in time. Momentum was assessed by fund flows. It was usually “the kiss of death” when individual investors flocked to equity markets, for instance. Risk management was an overall assessment of how the risk model was working.
Bullman said the risk strategy could be used as a tactical model alongside either traditional or lifestyle funds.
Two speakers at the conference addressed the trend, especially strong among US pension funds, to making asset allocations according to “risk parity”. This approach uses leverage to give each asset class equal weighting according to risk, to get rid of the overall bias to equity risk. It has been observed that a 60:40 equity:bonds portfolio can have a 90 per cent exposure to equity risk.
Michael Kitces, the head of research for Pinnacle Advisory in the US, said that risk parity portfolios “may well be just a fad, but I really do think they have the makings of a real trend”. He said the track record for the few funds which had been using the process for more than 10 years was strong. “They’ve held up well,” he said, “although they may have been biased by a bull market in bonds.” In any case, if risk parity portfolios trailed equities in a bull market “is that wrong?” he asked. Bonds are still only one-fifth of the risk exposure in a five-asset class model.
“Fundamentally, risk parity is just about better diversifying your exposure to risk and letting an even risk premia exposure deliver the returns as it eventually will, without taking a view or making a forecast,” he said.
Cliff Asness, the CIO and co-founder of US hedge fund manager AQR Capital, said his firm had been managing money, starting with the partners’ money, according to risk parity since 2006. “Over long periods, diversification benefits do enough to swamp being in a single asset class,” he said. Testing back to 1926 showed that equities had become more expensive over that time and bonds had “done a round trip”. Since 1986 bonds had done very well but so too had equities. Nevertheless, Asness said, investors were not being paid enough to accept 80-90 per cent of their risk in equities.
The “low-beta premium” played a role in the returns. This had become a fairly well established phenomenon in recent years – where less volatility, either in individual stocks or the whole market, led to better returns.
“Risk parity is not a bet on bonds, but a balanced bet on everything,” Asness said. “It doesn’t need falling interest rates, although that would be enjoyable.”