The Hotbed of Risk Parity Innovation Is in… Wisconsin?

The philosophy of a whole-fund risk parity has taken root at two of the state's leading institutions—along with something extra.

“We were never ones to follow the norm, to do what other people did,” confesses Carrie Thome, Wisconsin Alumni Research Foundation’s (WARF) director of investments. “After all, we started with an 80/20 portfolio before we went all risk parity.”

All risk parity? Yes. WARF’s $2.7 billion—managed by a seven-member team in offices overlooking Madison, Wisconsin’s Lakes Mendota and Monona—is entirely run with a risk parity approach.

Since 2004, the team has developed, executed, and tweaked the strategy to meet the foundation’s specific job of supporting the University of Wisconsin-Madison’s research. Thome says risk parity has become more than just a product—it’s a philosophy. “There is no perfect portfolio,” she continues. “We’ve found something that works for us. We have gone through the worst of the financial crisis with it. We understand what it can do for us under different market environments and we believe in it.”

2004 was a truly auspicious time for these true believers: right time, right people, and right strategy. Concerned by WARF’s high equity risks, the investment board wanted to move away from the 80/20 portfolio and take a more strategic approach. The foundation’s then-new leader—Tom Weaver, formerly of Fairfax County Employees’ Retirement System in Virginia—already came prepared with research, quantitative data, and detailed models for risk-balanced investing. “The board was naturally nervous at first,” Carl Gulbrandsen, WARF’s managing director, recalls. “The trustees were uncertain about the use of leverage and derivatives—they were bad words in the industry back then. It also probably wasn’t the best time to move away from the booming equities market, but in the end, we weighed the opportunity costs and decided it made sense.”


Consultants agree that these concerns are legitimate. As with any nontraditional strategy, there are certain levels of discomfort for some—uneasy “leaps of faith,” according to Callan Associates’ Eugene Podkaminer, who specializes in risk parity and risk-factor investing. “There is a lot to consider under the umbrella of risk parity,” he says. “For example, how do you define return, risk, and correlation? Certainly, there are industry standards, but they are not all accurate. It also bothers some practitioners that risk parity only looks at risk instead of trying to forecast returns, forgoing pieces of information we usually consider with a traditional asset allocation scheme.” The explicit use of leverage and derivatives could also be daunting for some asset owners, Podkaminer adds.

NEPC’s Kristin Reynolds likewise underscores the discrepancy between the perception of risk parity and its reality. Levering bonds may seem to add a great deal of bond risk to the portfolio—which may hurt the total portfolio when interest rates rise—but Reynolds says risk parity actually offers more stability with returns than the traditional asset allocation, even in a changing rate environment.

These apprehensions can naturally multiply when risk parity is applied to the entire portfolio, as it is at WARF, but Thome says mediocre past performance with high levels of equity risk added support for Weaver’s more moderate portfolio. “I don’t think everyone knew exactly what risk parity was at the time,” she says. “But we trusted Tom. The theory was reasonable. And we needed change.”

However, this isn’t to say that Weaver’s proposals hit the bullseye. Trial and error were the words to live by at WARF prior to the imminent financial crisis. Difficult decisions were made: the foundation retained new consultants, hired and fired in-house talent, and analyzed and reworked its approaches to each asset class. Thome admits since she took over the reins in 2007, WARF has changed its implementation strategy with commodities three times—from just using futures, to employing active managers, to now using one manager and the Clifton Group’s models. The team also took leverage off in 2008 until the following year, significantly strengthened risk management after the crisis, and continued to diversify, adding real estate, frontier market exposures, private equity, and venture capital.

But most pioneering of all is WARF’s $1.1 billion alpha portfolio, currently led by 32-year-old Assistant Portfolio Manager Ryan Abrams and embedded in the overall risk parity framework. “The goal is to gain consistent returns regardless of what is happening in the market,” he explains. “We search for true skill-based alpha in the form of highly diversified hedge funds that is completely uncorrelated to any asset class in the beta portfolio.” And according to WARF’s data, the alpha portfolio—nearly 42% of the total capital allocation as of December 31, 2014—accounts for only 8% of the overall risk. Not only do these alpha mandates result in relatively low risk, the foundation also employs a beta overlay intended to increase the exposure to traditional asset classes. Data shows WARF’s total beta portfolio had roughly $2.9 billion in futures and swaps, $1.1 billion in public securities, $300 million in private securities, and $200 million in cash resulting in 92% of risk allocated to the beta portfolio.


“This idea of an alpha portfolio in addition to risk parity is a natural progression,” argues NEPC’s Reynolds. “By buying cheap beta and getting market exposures through futures, asset owners could turn their resources to seeking the best alphas out there.” Thome says this part of WARF’s portfolio is the most labor-intensive and requires much vigilance. “At this point, our beta portfolio is comfortably set,” she explains. “It does require religious rebalancing, but we’re not looking to make drastic changes. But with the alpha portfolio, we found that it could very easily underperform when we aren’t too diligent.” And that’s where Abrams comes in. He says he is most concerned about misidentifying true alpha and accidentally adding beta—and more risk—to the portfolio.

Similar concerns were found next door at the State of Wisconsin Investment Board (SWIB), which manages more than $100 billion for the state’s retirement system, among other trusts. An early mover into risk parity, SWIB has been building out its allocation since 2010, shortly after the fund realized it needed to diversify away from regions of the world where equities did not perform well. “We thought of risk parity as an umbrella,” SWIB’s CIO David Villa says. “Umbrellas are worth more when it’s raining than when it isn’t.”

But implementing the strategy at the public pension fund is an entirely different beast than at WARF’s endowment: Working constantly under the spotlight, it also has a unique pension system to maneuver (Wisconsin discounts liabilities at 5% and has no cost of living adjustment). With an internal staff of more than 70, SWIB found slow and steady wins the race, choosing to allocate methodically, currently with about 6% risk parity against the target of 20%.

Taking one step further, the fund is also implementing a large-scale alpha portfolio supporting the alpha/beta separation concept. “The plan is to use a portable alpha structure, where we create market exposure synthetically and combine it with a low-risk, low-return, pure alpha hedge fund portfolio to create a better combination of the policy portfolio and active return,” Villa says. Dominic Garcia, SWIB’s senior fund-of-funds manager and the man tasked with leading the alpha portfolio, says the key is to add consistent, uncorrelated returns with lower volatility than the total portfolio. But weeding out the masters of disguise and avoiding levering more beta is no easy task. “A lot of what is promoted as alpha is just beta in fancy dress. It’s really hard to find portfolio strategies and managers that are generating true, uncorrelated, idiosyncratic excess returns—real alpha,” Villa says. Garcia adds that the execution of risk parity and the alpha portfolio may be works in progress, but like at their smaller brethren down the road at WARF, the philosophy has already taken root at SWIB.