It has been almost five years since United States asset consultant Pension Consulting Alliance, now called Meketa Investment Group, approached its clients with a new way of managing risk to combat severe equity crises.
Since then, this strategy – sometimes called crisis risk offset or risk mitigation strategy – has faced some real challenges.
The most confronting one was in February 2018, when equities sold off across the globe, but trend-following managers, which represent a large sleeve in these types of strategies, also experienced significant losses.
Several months later, a similar event took place, when trend following wasn’t able to provide the reprieve that was expected during an equity sell-off in October of that year.
Some institutional investors lost faith in the new approach.
CalSTRS, however, didn’t.
The beauty of having separately managed accounts was that we could see how the positioning was changing and we understood why trend-following managers were so long equities
In February 2016, CalSTRS revealed a risk mitigation strategy that embraced trend following (45 per cent of the sleeve) and global macro strategies (10 per cent of the sleeve) as important parts of its investment approach.
The portfolio manager in charge of this strategy is Carrie Lo and although she acknowledges the difficulties the strategy faced last year, Lo says the stakeholders of the US$238 billion fund didn’t second guess the approach.
“The short answer is no, they didn’t lose faith,” she says in an interview with [i3] Insights.
“The beauty of having separately managed accounts was that we could see how the positioning was changing and we understood why trend-following managers were so long equities.”
Lo had briefed the board and investment committee that they should expect trend-following strategies to struggle 75 per cent of the time.
“It was important to manage expectations ahead of time and in our asset allocation study we showed that yes, these assets are underwater a large amount of the time and the returns are very lumpy, but when we need it, we expect them to perform,” she says.
“Also, over time they should still produce a positive real return.”
Given the nature of trend-following returns, the investment committee also approved the inclusion of global macro and systematic risk premia within the Risk Mitigating Strategies (RMS) allocation.
These strategies should partially offset the behaviour of trend following and also provide diversification benefits at different points of the economic cycle.
We are going to revisit the weight of each of the strategies within [the risk mitigating strategy portfolio]
Lo recently added alternative risk premia strategies to the RMS sleeve, although this allocation is still in its early days.
“Currently, it is 5 per cent of the risk mitigation strategy because it is an unproven strategy for us,” she says.
“There has been a plethora of academic research to support it, but we are starting out small and gathering data points to see how it performs. If we do find that there is a compelling reason to increase the allocation, then we could look at the 10 per cent range.”
Whether CalSTRS will increase the weight of systematic risk premia (SRP) strategies or adjust the weight of any of the strategies will be decided during an upcoming review of all weightings in the RMS sleeve.
“We are going to revisit the weight of each of the strategies within RMS. It will just be a rejig,” Lo says.
CalSTRS’ implementation of SRP strategies is not limited to just equities, but also includes fixed income, currencies and commodities.
“We wanted risk premia to be very diversified across risk factors, across asset classes,” Lo says.
“The SRP portfolio construction was customised to be sure that the factor exposure was complementary. Each SRP manager invests in multiple asset classes, so we get exposure from the whole slate of factors that we’ve selected, as well as all four asset classes.”
She says the unexpected return of the value factor in September this year shows it is important to be diversified, as it is difficult to time these events.
“Value hasn’t been working well in many asset classes, globally, which is a bit anomalous. But in September, we saw that it did work well while other factors didn’t,” she says.
“There might be long periods when a particular factor is underperforming, but generally over time it should complement the strategy.”
SRP is also implemented in the commodity asset class, where the fund targets value and term structure premia, an approach few institutional investors have implemented yet.
Carrie Lo spoke at the [i3] Global Investment Strategy Forum, which was held on 16 and 17 October 2019 at the ParkRoyal on Pickering in Singapore.