In a Webcast hosted by PLANSPONSOR and its sister publication aiCIO, David Glutch, client portfolio manager, Global Asset Allocation at Invesco, explained that risk parity is an alternative form of portfolio management that allocates capital based on the underlying risk of asset classes, rather than anticipated returns. Risk parity will balance asset classes so that no class dominates; investors win by not losing, he added.
Risk parity is an important consideration for defined contribution (DC) plans because target-date funds (TDFs) are predicted to become the largest recipient of DC contributions and assets from investors in general. The “to” versus “through” retirement debate is important, but it is not the core issue, Glutch contended. The issue should be the asset-allocation framework and embedded assumptions; equity dependence is still an issue. TDFs struggled in 2008 because of an over-reliance on equity exposure. Near-date TDFs are highly sensitive to equity drawdowns, but there is also still a lot of equity in later-date TDFs.
Some argue that participants who continued investing in TDFs are now back to even, but being back to even is not a good thing, Glutch said. This assumes that TDF investors are young enough to take that risk, and it assumes no disruption in income.
With TDFs, the industry needs to think of a better way to construct asset allocation to address the downside risk. The objective for a TDF should be to preserve value in any economic environment as well as outperform cash at all times; this has significant ramifications for choosing asset allocation, Glutch contended. One must understand how asset classes behave in three economic environments: recession, inflation, non-inflationary growth.
Glutch explained that during inflationary growth, commodities, direct real estate, infrastructure and Treasury inflation-protection securities (TIPS) investments perform better. During non-inflationary growth, active equity and high-yield debt all mitigate risk. During a recession, cash and government bonds help to balance risk.
As an example, he said that in addition to stocks and bonds, the TDF could include commodities; an asset allocation equalizing risk would be 60% bonds, 20% stocks and 20% commodities. This will result in a better risk-adjusted return in all environments, and also offer a better path dependency on returns that is more favorable to investors at retirement taking distributions, Glutch said.
The fund’s glide path with risk parity will look different. The portfolio maintains an equal risk exposure to each asset class, so when an asset class is reduced in the glide path, the risk exposure will be reduced.
Risk parity could be a satellite holding for total portfolio allocation, as outlined in Glutch’s example above, or it could be the core design: conservative, including absolute return strategies and asset classes for each of the three economic situations.