Risk Parity Looking at Risk Through a Different Lens

Risk Parity Looking at Risk Through a Different Lens December 2015 Risk. Reinsurance. Human Resources.

Key Points Assets under management for risk parity strategies continue to increase steadily Investors should consider the advantages and disadvantages of a risk parity mandate Risk parity can be a complementary strategy to a multi-asset portfolio Allocations to risk parity should be meaningful enough to have an impact on performance at the overall portfolio level What is Risk Parity? In 2012, we authored the paper Risk Parity and the Limits of Leverage, in which we described risk parity as an investment strategy that focuses on the balanced allocation of portfolio risk rather than on the allocation of capital across assets. 1 Diversification is known as one of the few free lunches that investment markets offer. It is the principle that a portfolio can be made more efficient by combining different asset classes that are not perfectly correlated. A diversified portfolio of assets can exhibit a lower volatility for a given expected return, or a higher expected return for a given volatility, than could be achieved with any asset class individually. What is less well understood is that a portfolio that is well diversified based on the monetary amount invested in different asset classes may be very undiversified when it comes to the sources of risk in the portfolio and the drivers of performance. For example, over the past 43 years, the correlation between U.S. equities and a 50/50 portfolio of U.S. equities and Treasuries has been close to one (actual figure = 0.96). The risk in the portfolio has been dominated by the equity component even though assets have been allocated equally across the two asset classes. Even a portfolio that invested 80 percent in Treasuries and 20 percent in equities would have had a correlation of 0.75 with equity markets. Equities are dominant driver of returns even when allocations are relatively low (1973 2015) Correlation of Total Portfolio with Equity 1.0 0.8 0.6 0.4 0.2 0.0 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Equity allocation Source: Datastream, Aon This can also be seen in the charts below, which contrast for a portfolio (60% Global Equities, 30% U.S. Treasuries, 10% Alternatives), with the difference between where assets are allocated and where risk is 1 Sebastian, Mike. Risk Parity and the Limits of Leverage. Journal of Investing. Fall 2012, Volume 21, No 3. Risk Parity Looking at Risk Through a Different Lens 1

allocated. Equities dominate the risk allocation and while bonds represent a significant part of the asset allocation, they are far less significant in risk terms. Capital Allocation Risk Allocation Global Equities U.S. Treasuries Alternatives Source: Aon Hewitt, HFR Risk parity is an investment approach that seeks to redress these imbalances by focusing on achieving a balanced allocation of portfolio risk across assets rather than on the allocation of capital. The emphasis on risk as the primary driver of allocations produces portfolios that have lower exposure to return-seeking assets (such as equities) and much higher allocations to risk-reducing assets (high-quality bonds and inflation-linked government bonds) compared with many traditional portfolios. One downside of allocating more to fixed income at the expense of equities is that the portfolio has a lower expected return and lower expected risk than a traditional approach. While this portfolio may be more efficient (it has a higher Sharpe ratio) than a traditional approach and generate higher risk-adjusted returns, you can't eat risk-adjusted returns. Risk parity counters this issue by using leverage to raise the portfolio's expected volatility to specified levels depending on investor preferences. Often the portfolio is leveraged to result in a similar volatility to a traditional portfolio but resulting in a portfolio with a higher expected return. Development of the Risk Parity Asset Management Industry Risk parity is a relatively new strategy that has gained popularity with institutional investors in recent years. The strategy was pioneered by Bridgewater s AllWeather product in 1996, and the relative performance displayed during the 2008/09 financial crisis led to several other prominent asset management firms introducing products. The manager universe remains small, with fewer than 10 participants of meaningful size, but the strategy assets under management has shown steady growth to more than $150bn by the end of June 2015 (Source: evestment). Bridgewater manages the lion s share of the assets (>50%) but there are other multibillion strategy offerings from some well-established firms. The products are managed to a range of volatility levels, usually between 10 percent and 20 percent and there is at least one product designed for defined contribution plans with daily pricing. The approaches used by risk parity managers can be broadly classified into three main categories: Pure/passive where asset weightings are constantly rebalanced to ensure equal contributions to risk Active where the manager factors in its view of current market conditions, valuation levels, expected returns, volatility, and correlations Risk Parity Looking at Risk Through a Different Lens 2

Developed where there is additional flexibility to implement overrides such as stop loss triggers in fast-falling markets Timeliness Tactical or Strategic At a time when equity market volatility (risk) has recently increased, now would be a good opportunity to review how much equity market sensitivity should reside in portfolios. The appropriate level of equity market risk will vary depending on investor-specific factors including funded status (for pension plans), investment return targets, allocation restrictions, etc. However, as we feel the impact of greater volatility with increasing frequency and with a more muted outlook for investment returns compared to recent years, a consideration of the strategic case for an allocation to the risk parity strategy is warranted. Strategic Pros and Cons We have listed below some of the more commonly observed pros and cons of risk parity strategies. Pros Reduces dependence on equity market sensitivity Provides portfolio diversification benefits Affords exposure to leveraged credit and interest rate risks Provides access to talented managers Cons Introduces a level of conceptual complexity Potentially vulnerable to sharp upward interest rate moves and periods of market stress Accentuates liquidity and counterparty risk in crisis-induced market environments Perhaps the most differentiated advantage of risk parity is the exposure to leveraged credit and interest rates, which is unlikely to reside anywhere else in a traditional portfolio of assets. This can provide meaningful diversification benefits in a number of different market environments, and especially where correlation between the major asset classes is negative or very low and where the yield curve is declining or perpetually steeply sloped. Many portfolios today remain overly dependent on equity market returns with the overall risk (volatility) being dominated by equity investments. The inclusion of risk parity can go some way towards providing a more balanced approach to risk. On the other hand, the most cited disadvantage of risk parity is that the strategy will struggle to perform in an especially fast-rising interest rate environment. We looked at a number of product returns for risk parity strategies during recent periods of sharply rising interest rates or stressed markets Q2 2013, Q2 2015, and Q3 2015. Risk Parity Looking at Risk Through a Different Lens 3

Risk Parity Product Q2-2013 Q2-2015 Q3-2015 A -10.1% -2.5% -7.6% B -10.3% -1.5% -7.2% C -7.8% -3.3% -4.0% D -8.5% -3.1% -6.4% E -9.5% -4.3% -1.4% F -5.4% -3.5% -6.7% G -- -2.5% -4.3% MSCI ACW IMI -0.5% 0.5% -9.6% Barclays Global Aggregate -2.8% -1.2% 0.9% Source: Aon Hewitt and Investment Managers In the first period (the quarter of the so-called U.S. Federal Reserve taper tantrum), bond returns were sharply negative and this was accentuated through the leveraged bond positions of risk parity products; in the second period of negative bond returns the same observation can be made the risk parity products tended to fare worse; for the final period when equity returns were sharply negative, risk parity product returns were negative but not by as much as equity markets i.e., they afforded some relative protection. Portfolio Construction Considerations There are several ways that risk parity funds can be constructed. Historic volatility is normally a primary driver although the timescale used in these calculations varies significantly. We have used data since 1997, the longest common period for which we have data on each of global equities, U.S. Treasuries and TIPS, and commodities. We constructed a portfolio where the unlevered weight has been set such that each asset class contributes 25 percent of the total portfolio volatility, with the simplifying assumption that the asset classes are uncorrelated. This over-allocates to fixed income compared with a more traditional approach, and so results in a portfolio with a much lower risk but also lower expected return compared to a traditional portfolio. To counter this, we also constructed a levered portfolio that has been scaled to hit a 10 percent volatility target, an approach taken by many risk parity funds. In this case cash is required as a balancing item, as the total gross exposure exceeds 100 percent due to the use of leverage. Unlevered Weights Treasuries Global TIPS Commodities Cash Equities Volatility since 1997 4.5% 14.7% 5.8% 16.6% -- Risk parity weights (unlevered) 42.9% 13.0% 32.7% 11.5% 0.0% Risk parity weights (levered) 94.1% 28.5% 71.8% 25.2% -119.7% Source: Aon Hewitt One can observe the relatively low combined allocation to higher risk assets (Global Equities and Commodities) compared to most traditional portfolios; and how leveraging lower-risk assets (Treasuries and TIPS) maintains equal risk contributions when raising the weights of higher-risk assets in the levered portfolio. What is the impact on risk adjusted returns? Our work on capital markets assumptions (CMAs) suggests that even in an environment where we project low long-term risk-adjusted returns for bonds, risk parity may still have a place in a portfolio. Using the Risk Parity Looking at Risk Through a Different Lens 4

levered risk parity model portfolio with the weights illustrated in the previous section, together with our Q3 2015 10-year CMA, the Sharpe ratio is projected to be no worse than the ratio for a traditional 60/40 portfolio (see the chart below). 35% 30% 25% 20% 15% 10% 5% 0% Risk reward characteristics Risk parity 60/40 Return Vol Sharpe Source: Aon Hewitt Although risk parity is projected to earn approximately the same risk-adjusted return, it is not perfectly correlated with a 60/40 portfolio (our correlation assumption is 0.7). This means that combining risk parity with a 60/40 portfolio results in a portfolio with a higher Sharpe ratio than one comprised of only a 60/40 portfolio or only a risk parity fund. The chart below shows our analysis for various allocations to risk parity, from 0 percent to 100 percent. Portfolio Sharpe ratio 0.38 0.37 0.36 0.35 0.34 0.33 Portfolio Sharpe ratio for 60/40 + risk parity 0.32 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Risk parity allocation Source: Aon Hewitt However, the improvement is only minor (note the scale on the vertical axis) and given the uncertainties in setting long-term assumptions, it would be presumptuous to use this in isolation to specify an optimal allocation to risk parity. What we can say is that a portfolio may be made more efficient by making an allocation to risk parity, even on the basis of relatively subdued return prospects for fixed income. Risk Parity Looking at Risk Through a Different Lens 5

Correlations are Key In practice asset classes are not uncorrelated and for our own Capital Markets Assumptions (Q3 2015 10- year) we use the following correlations: Returns, Volatility, and Correlations Correlations Return Vol Equities Treasuries TIPS Commods Cash Global Equities 6.9% 17.4% 1.0-0.1-0.1 0.4 0.0 Treasuries (6yr duration) 2.4% 4.0% - 1.0 0.6 0.0 0.6 TIPS (8.5yr duration) 2.9% 6.0% - - 1.0 0.1 0.3 Commodities 4.5% 17.0% - - - 1.0 0.0 Gov Cash 2.1% 1.0% - - - - 1.0 Source: Aon Hewitt expected returns, volatility, and correlations Since we assume that bonds are negatively correlated with equities (-0.1), this means that bonds can play an important role in portfolio structuring even though, on the basis of our assumptions, they offer poor expected returns in isolation. If, rather than assuming the correlation between the two asset classes is -0.1, we instead assumed it was +0.2, the benefit of leveraging bonds in a risk parity portfolio becomes less helpful to portfolio construction. Although a selling point of risk parity is that it supposedly avoids the need to make forecasts about a highly uncertain future when setting asset allocation, it implicitly (or explicitly) makes assumptions about the correlation between different asset classes. Different correlation assumptions can result in very different portfolios. One thing we know for sure is that correlations are highly variable and the equity/bond correlation goes through periods of being positive and negative (see our note: The equity-bond correlation: The most important number you rarely think about, August 2014). We would question whether it is easier to forecast correlations than it is to forecast returns, especially in an environment where both asset classes have benefited from central bank support and both are vulnerable to a setback when that support is withdrawn. The equity-bond correlation could switch from negative to positive over a very short time horizon, and this represents one of the biggest challenges facing risk parity funds, especially given the use of leverage. A Look at Downside Risk One way of assessing downside risk is to consider the fifth percentile annual return (or a 1 in 20-year event) from a series of forward-looking simulations using our capital market assumptions. On this basis, we project that a fifth percentile event for a traditional 60/40 portfolio is a loss of almost 13 percent but a risk parity fund will experience lower losses of only 11 percent. Because the traditional portfolio and the risk parity fund are not perfectly correlated, blending them together can reduce risk relative to either in isolation. Our analysis shows that adding risk parity to a traditional 60/40 portfolio can be expected to reduce downside risk. Risk Parity Looking at Risk Through a Different Lens 6

Downside risk analysis 8% 5th percentile annual return 9% 10% 11% 12% 13% 14% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Risk parity allocation Source: Aon Hewitt However, simple measures of volatility may not fully capture all of the risks of investing in risk parity, given the leverage employed. Leverage introduces additional tail risk into a portfolio that is not captured by volatility as a measure of risk when the return distribution is skewed. Falling markets or a liquidity crunch could lead to forced sales of derivatives to make margin calls. While an unleveraged investor could stomach a decline in value so long as the value recovered in future, a leveraged investor may be forced to unwind some of their positions to meet margin calls. This would mean they could miss out on some or all of any rebound, leading to a permanent loss of capital. In addition, our approach above assumes that leverage costs are driven by cash rates, but the reality is that some form of additional credit costs are likely to be borne and the cost of this borrowing could spike dramatically in certain situations. What happens as yields rise? We expect yields to rise over time but this is already largely reflected in current market pricing. For example, as of 12/01/2015, the market is pricing that the 10-year Treasury will rise from around 2.1 percent to almost 3 percent over the following three years. Our central expectation is that yields could rise by slightly more but the difference is not large. In this environment 10-year Treasuries are expected to earn barely positive returns. Consequently we have a moderately bearish view on U.S. fixed income. The current market environment impacts risk parity in a number of ways: 1) Our Medium Term View (MTV) is for bonds to underperform our long-term CMA over the coming years. While we also think equities returns could undershoot our long-term assumption over the medium term, we believe that risk-adjusted returns for equities are likely to exceed those of bonds. This suggests that it is not an opportune to time to raise exposure to bonds relative to equities from a return-seeking perspective. a) We believe risk parity will underperform a 60/40 portfolio in an environment where interest rates shock upwards, as happened during the taper tantrum. Risk Parity Looking at Risk Through a Different Lens 7

b) However, this is not the same as saying that risk parity is likely to lose lots of money in the current environment. Risk parity may still generate positive returns in an environment where interest rates rise gradually over time. c) Our MTV is that yields will rise by slightly more than priced into the curve over the coming years but we are not forecasting a major shock. This is unhelpful for risk parity but need not be devastating for its prospects. d) What it is equivalent to saying is that risk-adjusted return prospects for risk parity funds could fall behind those of a traditional 60/40 portfolio over the medium term. 2) However, the risk of a further prolonged period of low interest rates cannot be ignored and in these environments, risk parity could be expected to significantly outperform a 60/40 portfolio. We project that in either a secular stagnation (low growth/inflation) or a recessionary scenario, risk parity could be expected to outperform a 60/40 portfolio by 6 percent to 7 percent cumulatively over the next three years. 3) We are believers in diversification and our long-term capital market assumptions are that equities and bonds are negatively correlated. However, both have benefited from monetary stimulus over recent years and are at risk of falling in value when interest rates rise (see taper tantrum for an example of what could happen). Diversification may be less helpful if there is an interest rate shock. While such a major shock is not our central scenario, the risks can plainly be seen. The use of leverage exposes risk parity to this risk to a much larger extent than a regular 60/40 portfolio. This is one of the key risks for risk parity. 4) We have just come from a period of very low volatility but we expect volatility to pick up in the future. Any historic calculation of volatility used in forming a risk parity portfolio that places emphasis on recent (3- to 5-year) volatility is likely to suggest that significant leverage is required to attain a specified volatility target. This is likely to understate future volatility and could add significantly to risk. This can be seen in the details of the simple risk parity portfolios in the following exhibit. As before, our analysis sets the unlevered weights such that each asset class contributes 25 percent of the portfolio volatility, with the simplifying assumption that the asset classes are uncorrelated. These have then been scaled to hit a 10 percent volatility target. 300% Asset Allocation 200% Exposure 100% 0% 100% 200% Post 97 Last 10yrs Last 5yrs Last 3yrs Historic period used in volatility calculation Global dev equities Treasuries TIPS Commodities Cash Source: Aon Hewitt Risk Parity Looking at Risk Through a Different Lens 8

Portfolios that are formed using shorter-term volatility calculations end up being much more highly leveraged whereas those using longer-term volatility measures are less exposed to this risk and will exhibit more stable leverage multiples (but at the cost of potentially missing their volatility targets over shorter time horizons). We incorporate this factor into our assessment of different manager risk parity products. This can also be illustrated in the exposures of a simulated risk parity fund calibrated using a 3-year trailing volatility analysis. As can be seen from our analysis in the following exhibit, in the run-up to the financial crisis this fund would have raised leverage due to low realized volatility. In turn, this would have exposed it to increased losses when the downturn hit. Funds with a mechanical shortterm volatility rebalancing process would have been similarly affected in recent times. These features would be exaggerated for risk parity products running at higher target volatilities. 400% 350% 300% 250% Equity and Treasury weights for 10% volatility target Equities Treasuries 200% 150% 100% 50% 0% 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 Source: Aon Hewitt What to Do? If a portfolio has no existing allocation to risk parity, then consideration should be given to exploring the potential benefits that can arise. It is our belief that decision makers should be aware of and consider all investment strategies and their development over time. If a decision to invest is reached, then an allocation of less than 5 percent is unlikely to have a meaningful impact on portfolio characteristics. If a portfolio has an existing allocation to risk parity, then consideration should be given to its sizing, and the role that this plays in conjunction with the level of broader equity market sensitivity that is warranted. It is likely that a portfolio with a higher level of equity market sensitivity (beta) would have more appetite for risk parity than a portfolio with a lower level of equity market sensitivity. Also, very well-diversified portfolios are unlikely to derive as much benefit from risk parity inclusion as a traditional 60/40 portfolio. The final consideration is where a risk parity strategy should sit in a portfolio. It is our preferred approach to place it as part of a hedge fund or opportunistic allocation 2 in a portfolio rather than as a dedicated category for risk parity. 2 Opportunistic allocations are described in detail in our white paper The Opportunity Allocation: A Tool to Provide Maximum Flexibility with Implementation. (May 2013). Risk Parity Looking at Risk Through a Different Lens 9

Contact Information Peter Hill Partner, Global Head of Liquid Alternatives Aon Hewitt Investment Consulting, Inc. +1.312.381.1243 peter.hill@aonhewitt.com Duncan Lamont, CFA Principal, Asset Allocation Aon Hewitt Global Investment Consulting Practice +44 (0) 20 7086 9168 duncan.lamont.2@aonhewitt.com Risk Parity Looking at Risk Through a Different Lens 10

About Aon Hewitt Investment Consulting, Inc. Aon Hewitt Investment Consulting, Inc., an Aon plc company (NYSE:AON), is an SEC-registered investment adviser. We provide independent, innovative solutions to address the complex challenges of over 480 clients in North America with total client assets of approximately $1.7 trillion as of June 30, 2014. More than 270 investment consulting professionals in the U.S. advise institutional investors such as corporations, public organizations, union associations, health systems, endowments, and foundations with investments ranging from $3 million to $310 billion. About Aon Hewitt Aon Hewitt empowers organizations and individuals to secure a better future through innovative talent, retirement, and health solutions. We advise, design, and execute a wide range of solutions that enable clients to cultivate talent to drive organizational and personal performance and growth, navigate retirement risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability, and wellness. Aon Hewitt is the global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information, please visit aonhewitt.com. Aon plc 2015. All rights reserved. Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon Aon Hewitt Investment Consulting s preliminary analysis of publicly available information. The content of this document is made available on an as is basis, without warranty of any kind. Aon Hewitt Investment Consulting disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. Aon Hewitt Investment Consulting reserves all rights to the content of this document. Risk Parity Looking at Risk Through a Different Lens 11