Risk parity and factor Investing

19 February 2014 Vincent de Martel, CFA, Managing Director What is Risk-Based Investing?

Risk-Based Investing  Allocating risk instead of capital Risk-Based Investing Risk Parity  The special case of risk-based investing where risk allocations are equal

Risk Factor Investing Risk Parity Investing  Allocating not to asset classes but to risk factors. Examples: The small cap premium, Liquidity premium

Proprietary and Confidential: This material may not be distributed beyond its intended audience. 1 There is strong evidence of the existence of a investment

 From an empirical perspective  From a theoretical perspective

Equity returns compared with inflation since 1871

1000000

100000

10000

1000 Logscale

100 Inflation (CPI) Equities (S&P composite) 10

1 1871 1875 1879 1883 1887 1891 1895 1899 1903 1907 1911 1915 1919 1923 1927 1931 1935 1939 1943 1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011

But risk matters

Source: Market Volatility, R. Shiller, MIT Press, 1989, and Irrational Exuberance, Princeton 2005

Proprietary and Confidential: This material may not be distributed beyond its intended audience. 2 Lessons learnt from 30 years of investing in economic risk

MSCI World Index: most negative monthly returns of the past 30 years

Source: BlackRock, Datastream

Proprietary and Confidential: This material may not be distributed beyond its intended audience. 3 A balanced

 An entrepreneur wants an increase in wealth over a 10-year period with reasonable certainty  Decides to diversify by allocating an equal amount of dollars to two projects

Project A - $50m Project B - $50m

Power plant Hyperloop

Chance of losing $50m over 10 years: ≈ 0% 30% chance of losing $50m over 10 years

 This is not a balanced portfolio. 99% of the risk comes from project B  Why bother with project A in the first place?

Source: Pixabay.com Source: gas2.org

Proprietary and Confidential: This material may not be distributed beyond its intended audience. 4 The experience of investing in equities and balanced portfolios

Drawdowns from previous high for an equities and 60/40 portfolio 0%

-10%

-20%

-30%

60 Equities / 40 Bonds -40% Developed Equities

-50%

-60% 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

 We have only just recovered from the losses started in 2007

Source: BlackRock

Proprietary and Confidential: This material may not be distributed beyond its intended audience. 5 Using asset classes to achieve diversification is helpful

Identifying optimal portfolios requires only three pieces of information 1. 2. Risk 3. Correlations

Covariance matrix

1.0 -0.5 -0.3 0.0 -0.1 0.5 0.8 0.6 0.3 0.4 0.3 0.5 -0.3 0.2 USD.Cash -0.5 1.0 0.8 0.7 0.7 0.0 -0.6 -0.4 -0.1 0.0 0.3 0.2 0.2 0.0 IL.Debt -0.3 0.8 1.0 0.8 0.8 0.3 -0.5 -0.3 0.1 0.1 0.3 0.4 0.2 0.1 Dev.Sov.Debt 0.0 0.7 0.8 1.0 0.7 0.3 -0.3 -0.2 0.0 0.1 0.4 0.5 0.0 0.0 IG.Debt -0.1 0.7 0.8 0.7 1.0 0.5 -0.2 0.0 0.3 0.3 0.5 0.6 0.3 -0.1 EM.Sov.Debt 0.5 0.0 0.3 0.3 0.5 1.0 0.4 0.5 0.8 0.6 0.6 0.7 0.3 0.0 HY.Debt 0.8 -0.6 -0.5 -0.3 -0.2 0.4 1.0 0.9 0.5 0.7 0.5 0.4 0.1 0.3 Dev.Equity 0.6 -0.4 -0.3 -0.2 0.0 0.5 0.9 1.0 0.7 0.9 0.7 0.5 0.4 0.4 Dev.Sml.Cap.Equity 0.3 -0.1 0.1 0.0 0.3 0.8 0.5 0.7 1.0 0.8 0.7 0.5 0.5 0.3 EM.Equity 0.4 0.0 0.1 0.1 0.3 0.6 0.7 0.9 0.8 1.0 0.8 0.7 0.4 0.4 Listed.Private.Equity 0.3 0.3 0.3 0.4 0.5 0.6 0.5 0.7 0.7 0.8 1.0 0.7 0.4 0.5 Infrastructure 0.5 0.2 0.4 0.5 0.6 0.7 0.4 0.5 0.5 0.7 0.7 1.0 0.0 0.2 Property -0.3 0.2 0.2 0.0 0.3 0.3 0.1 0.4 0.5 0.4 0.4 0.0 1.0 0.2 Ex.Energy 0.2 0.0 0.1 0.0 -0.1 0.0 0.3 0.4 0.3 0.4 0.5 0.2 0.2 1.0 Energy USD.Cash IL.Debt Dev.Sov.Debt IG.Debt EM.Sov.Debt HY.Debt Dev.Equity Dev.Sml.Cap.Equity EM.Equity Listed.Private.Equity Infrastructure Property Ex.Energy Energy  In practice though, asset class returns overlap

Source:BlackRock

Proprietary and Confidential: This material may not be distributed beyond its intended audience. 6 Asset class returns can be attributed to only six risk factors

Risk Factors Asset Class

Inflation- Real rates protected bonds

Nominal Real rates Inflation bonds

Corporate Real rates Inflation Credit bonds

High yield Real rates Inflation Credit Liquidity bonds

Small cap Real rates Inflation Credit Liquidity Economic equities

Emerging Real rates Inflation Credit Liquidity Economic Emerging equities

Source: BlackRock.

Proprietary and Confidential: This material may not be distributed beyond its intended audience. 7 The fundamental sources of return

Source Description Example

Economic Return premium associated with economic growth Developed equities, commodities, and property

Credit Return premium from lending money to corporations Corporate bonds versus government bonds

Emerging Return premium from investing in emerging market Emerging markets versus developed markets markets equities, bonds, and currencies

Return premium associated with financial market and Small cap equity versus large cap equity Liquidity asset class

Return premium from lending money for a period of Globally diversified inflation-linked government Real rates time portfolio

Inflation Return premium from bearing inflation exposure Nominal bonds versus inflation-linked bonds

Proprietary and Confidential: This material may not be distributed beyond its intended audience. 8 Asset classes deliver cash returns + a blend of risk premia. Example 1

Inflation-protected bonds returns

Barclays World Govt Inflation Linked Bond USD Hedged Index Log scale Log

Cash Returns from real rates risk premium Inflation-protected bonds

simulated

Log scale Log + =

actual

Source: BlackRock

Proprietary and Confidential: This material may not be distributed beyond its intended audience. 9 Asset classes deliver cash returns + a blend of risk premia. Example 2

Listed property returns (REITS)

FTSE EPRA/NAREIT Global TR Log scale Log

Cash Real rates Inflation Credit Economic Listed property

simulated

Log scale Log + =

actual

Source: BlackRock Liquidity Emerging markets

Proprietary and Confidential: This material may not be distributed beyond its intended audience. 10 The goal - achieving growth at reasonable risk…

Global pension assets Risk factor portfolio

 Overexposed to economic risk  Balanced across fundamental sources of return  Underexposed to other sources of return

Economic risk Economic risk

Risk factor portfolio versus average pension

 Redistribute sources of return and maintain return expectations

As of September 2013. SourceTowerswatson.com (Global Pension Assets Study 2013), Mercer.com (Asset Allocation Survey), FTSE (FTSE All-World index), BlackRock. The top level allocation is 47% equities 34% bonds 18% alternatives 1% cash. Global pension assets include defined contribution and defined benefit plans.

Proprietary and Confidential: This material may not be distributed beyond its intended audience. 11 …and across market environments

The graph below shows the comparative average performance of a risk factor portfolio and 60% equities 40% bonds in four economic regimes defined by growth and inflation changes (1990-2013)

Growth rising Growth rising Growth falling Growth falling Inflation rising Inflation falling Inflation rising Inflation falling

Factor 1.2% Portfolio

RealRates 0.9% 60/40 Factor Factor Inflation Portfolio Portfolio Credit 0.6% Factor Economic Portfolio 60/40 Political 0.3% 60/40 60/40 Liquidity Total return 0.0% Monthly Excess Return -0.3%

-0.6%

Factor portfolio relative allocations: Real Rates 27%, Inflation 10%, Credit 10%, Economic 28%, Political 17%, Liquidity 7%, rebalanced monthly.

Source: BlackRock. Growth rising/falling is defined by a 3-month increase/decrease in US ISM Manufacturing Index. Inflation rising/falling is defined by a 3-month increase/decrease in the 12-month % change of the US PCE Index. Excess returns for each risk factor are reported from January 1990 to January 2013 60/40 Blend: 60% MSCI World USD Hedged net return, 40% Barclays US Aggregate TR, rebalanced monthly.

For illustrative purposes.

Proprietary and Confidential: This material may not be distributed beyond its intended audience. 12 Advantages and disadvantages of a risk factor approach

Pros Cons

 Better understanding of return and risk. Asset class  No recognized list of factors characterizations can be too broad (e.g. private equity)  Use of derivatives and short positions  Portfolios more robust to market regimes  The need for frequent or active rebalancing of the risk  Weighing the addition of new factors or asset classes factor building blocks to the portfolio and how large the allocation should be  By itself, using risk factors should not be a superior  Better evaluation of benefits of active management approach since both asset classes and risk factors are exactly identical

Proprietary and Confidential: This material may not be distributed beyond its intended audience. 13 We need a better framework for understanding risk and return

Fat

Fat Sugar Sugar Salt Proteins Salt Vitamins

Proteins Vitamins High calorie content, but unbalanced Balanced, but leaves you hungry

Fat

Sugar

The solution? Salt

Same amount of calories as a burger Proteins As balanced as a salad

Vitamins

For professional clients / qualified investors only Summary

• Risk-based investing is expanding into multiple segments

• More crises to come: stay balanced

• Balance fundamental not asset classes

The information and opinions herein are provided for informational purposes only, are subject to change and should not be relied upon as the basis for your investment decisions. Past performance is not necessarily indicative of future performance. This document is not and should not be construed as a solicitation or offering of units of any fund or other security in any jurisdiction. No part of this publication may be reproduced in any manner without the prior written permission of BlackRock.

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For professional clients / qualified investors only