Which Risk-Parity-Based Pension will Blow up First?

A real basic question: Is risk parity driven by the long-bond?

Yes.

Another real basic question: Which pension following risk parity will blow up first?

A real basic answer: pension funds levering up US T-Bonds!!!

An intriquing WSJ article on the topic of risk parity:

http://online.wsj.com/article/SB10001424127887323301104578255641599364884.html

Some extra special comments:

In Virginia, officials at the Fairfax County Employees’ Retirement System have revamped the entire $3.4bn portfolio around a risk-parity approach. About 90% of the pension’s portfolio now is exposed to bonds, when factoring in leverage. “We think we can improve returns while reducing the risk level of the portfolio,’ said Robert Mears, the pension fund’s executive director.

Risk parity’s growing popularity comes at a fragile time in the bond market. Some critics warn the strategy may fizzle if interest rates rise and erode bond returns. There is “reasonable concern” that could happen once the bull market for bonds cools, said Mark Evans, a managing director at Goldman Sachs Asset Management, a unit of Goldman Sachs Group. That factor “isn’t likely to be there going forward for a number of years.”

The employee pension fund of United Technologies has gradually increased its risk parity-related investments to $1.8bn, or about 8% of its total assets, up from an initial 5% allocation in 2005. At the San Joaquin County Employees’ Retirement Association, in Stockton, California, risk parity now amounts to 10% of the pension’s overall portfolio of approximately $2bn. In an email, the pension fund’s chief investment officer said the fund “is aware of the leverage being utilised in their risk-parity strategies and has no misgivings.”

Some interesting food for thought:

Meb Faber’s article: What if 8% is Really 0%? Pension Funds Investing with Fingers-Crossed and Eyes Closed

It is well known that pension funds in the United States are underfunded even if they achieve their projected 8% rate of return. The scope of pension underfunding increases to an astonishing level when more probable future rates are employed. A reduction in the future rate of return from 8% to the more reasonable risk-free rate of approximately 4% causes the liabilities to explode by trillions of dollars. As bond yields declined over the past twenty years, pension funds moved toward more aggressive equity-based portfolios in an attempt to reach for this 8% return. By investing in a portfolio with uncertain outcomes, pension funds could experience increasingly volatile and even negative returns. Paradoxically, in an effort to chase the universal 8% rate, pension funds may be laying the groundwork for returns even lower than the risk free rate. In an effort to offer an empirical basis for this possibility, we conclude the paper with a relevant comparison – the return of a hypothetical Japanese pension for the past two decades. We believe that pension funds need to at least prepare for the unfathomable: 0% returns for 20 years. Most pension funds, regrettably, have not adequately stress tested their portfolios for these scenarios.

Disclaimer

I actually appreciate the risk parity idea and utilize it in different capacities. However, ALL trading strategies freak me out when everyone and their sister is involved. It is just a matter of time before the “liquidity event” hits the risk parity crowd. Meb has a nice list of the numerous players here.