Opinion and Investing

SKARBECK: 'Parity' strategies confuse market volatility with risk

November 19, 2011

Ken Skarbeck InvestingMajor changes in investment strategy are under way at Indiana’s public pension funds. The process of integrating the $15 billion Indiana Public Employees’ Retirement Fund, the $8.4 billion Indiana State Teachers’ Retirement Fund and five smaller funds under one umbrella has resulted in a new organization called the Indiana Public Retirement System, overseeing $23.5 billion. And the streamlined entity has established a set of operational, investment and administrative goals in hopes to better serve the retirement needs of Indiana’s public employees.

Notably, INPRS will undertake a significant shift in investment strategy by implementing a technique called “risk parity.” In a conventional investment portfolio, stocks are more volatile than bonds. The basic idea behind risk parity is to reduce the weight of stocks and increase the weight of bonds to balance the volatility.

The Indiana entity hopes to accomplish this by selling one-third of its U.S. and international stocks and shifting the money into fixed income and commodities, while adding leverage to the portfolio. The organization calculates that the risk-parity strategy will slightly reduce overall risk, and slightly improve returns from a target of 7.5 percent to 7.52 percent.

After this shift, the new asset mix for the pension funds will be 22.5 percent U.S. and international equities; 22 percent fixed income, excluding inflation-linked securities; 10 percent inflation-linked fixed income; 10 percent absolute return or hedge funds; 10 percent private equity; 7.5 percent real estate; 8 percent commodities; and 10 percent risk parity.

However, by levering up the portfolio to 118 percent—borrowing money on margin—the effective asset allocation will be 25.5 percent equities; 32.5 percent fixed income, 10 percent hedge funds, 10 percent private equity, 16.7 percent real-return equity, and 23.3 percent real-return fixed income.

Skeptics see flaws in risk parity. The strategy is derived from the academic workings of modern portfolio theory. Detractors, myself included, believe that a major error in these theories is that they confuse volatility with risk. Our view is that volatility allows an investor the opportunity to acquire securities at attractive prices when the markets act depressed.

Also, pension plans have long time horizons—they are investing for generations of retirees. That being the case, should institutional investors be overly concerned with short-term market oscillations?

In addition, a risk-parity strategy runs the risk of loading up on fixed income following the best performance run for bonds in history. If bonds and commodities—now trading near their historic highs—were to turn in poor performance, the leverage in the risk-parity strategy will enhance losses.

Clearly, institutional investors are doing everything they can to be less correlated to the stock market—again driven by data demonstrating a decade’s worth of poor stock performance. Yet the depressed mood of Mr. Market has knocked down stock valuations to levels where equities are now quite attractive for the long term.

All pension plans are being pitched these types of volatility-reduction strategies by their consultants. Yet we would conclude that they are reducing their exposure to equities at the very time they should be increasing their allocation.



This was my 200th column. I want to thank the Indianapolis Business Journal for allowing me to write and thank you for reading.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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