The New Mexico Public Employee Retirement System (PERA) has implemented a new risk parity strategy, taking the investment option in a more passive direction.
The index-based approach is part of the $15.4 billion fund’s plans, adopted by the board last July, to reconfigure its strategic asset allocation.
The plan specifically targets the multi-risk allocation strategy, which is new to it. This is comprised mostly of risk parity-type strategies, which aim to protect assets against financial threats such as inflation. It is also referred to as the “all weather” tactic, coined by Bridgewater Associates’ Ray Dalio.
“We were careful in our process,” said Kristin Varela, the fund’s deputy chief investment officer. She said the PERA wanted to create a plan that aligned with its goals to split alpha and beta exposure, as well as “prudently budget active risk.”
Varela told CIO the strategy has the potential to “normalize” the fund’s risk parity as the PERA can now passively implement its beta exposure into a low-cost and transparent vehicle. She also said the new index will help manage mitigate tracking errors associated with risk parity, as it doesn’t have a specified benchmark.
The reason: the decade-old strategy is fairly new to the investment world and has yet to achieve widespread adoption, according to Wilshire Analytics Managing Director Robert Waid. He told CIO previous benchmarking concepts saw pension funds using either equity-based indexes such as the S&P 500, traditional 60/40 portfolios, or a multi-asset peer group process. “None of those were really risk parity implementations that were investable,” said Waid.
New Mexico’s plans look to change that. “They didn’t want their active risk budget being consumed by a beta strategy,” Roberto Croce, Mellon’s managing director and senior portfolio manager, charged with running the passive risk parity operation, told CIO. “They really believe in the separation of active risk and alpha and that all active risk should be devoted to generating alpha and that all beta should live within its risk allocation with very little tracking error.”
“Identifying a viable index to integrate into policy was very important for us,” said Varela. “We recognized the inefficiencies in indexing such strategies and believed there could be a more robust solution available.”
How it Works
The initial allocations to the PERA’s new concept will be about 10% of the plan’s total portfolio. It will consider these assets as part of its beta exposure. Consultant Wilshire Associates assisted the New Mexico pension plan in finding the right index, which the PERA specified be low-cost.
Talks with Wilshire first began last summer, according to Jeff Foley, Wilshire Analytics’ head of business operations and managing director. The fund’s parity index splits risk equally into stocks, bonds, and commodities while targeting a 15% volatility. This allows each bucket to hedge against and perform with the others.
Foley told CIO that when New Mexico decided it would indeed invest in risk parity, the question was whether to go active or passive. He said when the fund looked at the available options for passive risk parity, they realized how limited the space really was. Once it hired Mellon Investment Corp. to implement the strategy, that got the ball rolling for Wilshire’s index construction.
“When we were contacted by New Mexico PERA and Mellon about the idea of creating an investable risk parity index, it was a great opportunity to take something we had interest in for quite some time and turn it into something we could put out in the market,” Foley said.
Wilshire didn’t just make one risk parity index, though. They made two more, each with different volatility targets: 10% and 12%, but the firm is open to making more down the road.
“A year from now or two years from now depending on the environment, the world may be clamoring for an 8% volatility target,” Foley said. “If that’s the case, we would do that.”
Croce runs all the risk parity strategies at Mellon, so when the firm asked him to handle the New Mexico plan’s passive idea, he jumped at the chance. “It basically asked…would we be willing to run a passive risk parity strategy,” he said. “Our response to that was: yes.”
Croce said it was essential the plan’s new strategy to keep the same value-added properties of risk parity: diversification, growth and inflation balance, and consistent delivery on targeted levels of risk.
“If you target 10% volatility, you realize something close to 10% volatility,” he said. “That’s something we’re adamant about because if we’re not generating the amount of risk that you’re targeting, you’re also not going to generate the amount of return that the investors have in terms of their expectations.”
Wilshire said it is in talks with other large pension plans that either currently have an active implementation and are considering shifting to passive risk-parity options, or, like the New Mexico PERA, have no risk parity allocations and want to get their feet wet.
“We’re excited about the opportunity set and really being able to bring a very robust option to a market that has a limited set of options,” said Foley.
Dominic Garcia, the New Mexico PERA’s chief investment officer, declined to comment.