A Different Approach to the Glide Path

Ryan Leggio: Hi, I am Ryan Leggio. I am a mutual fund analyst at Morningstar. With me today is Scott Wolle. He is the manager of the Invesco balanced-risk funds and Invesco's target-date fund lineup. Scott, thanks so much for being with us today.

Scott Wolle: My pleasure.

Leggio: So, your strategy employs was called a risk parity strategy. Can you talk a little bit about what that strategy involves?

Wolle: Sure. Well, risk parity is really quite simple in principal. What we try to do is balance the amount of risk that one set of assets will contribute to a portfolio along with all the others. So, in general, if you have a low-risk asset, that will have a high weight in the portfolio, whereas, high-risk assets will have a lower weighing.

Now, the big question is, what exactly do you balance? What are those groups of assets that should go together? And really in our case, the way that we thought about it was risk parity is just a tool to try to accomplish a goal, and that goal was to provide attractive total returns to investors. To do that, we wanted to avoid big downturns in the portfolio value, and so we're trying to balance how much risk we have associated with different kinds of economic outcomes. But other managers might do it differently.

Leggio: So, your strategy basically competes with a typical 60-40-balance-type approach, is that right?

Wolle: That's right.

Leggio: In terms of the asset classes involve, can you explain a little bit about the three buckets, you use: stocks, bonds, and commodities?

Wolle: Sure. Maybe the first step there is I talked about how much we try to balance the returns in different economic environments. And really the way we do that is to hold assets in the portfolio that should thrive no matter what the economic outcome is. So, we think of the three main economic environments as noninflationary growth, recession, and inflationary growth. So, the asset class that we have associated with those are equities for noninflationary growth, government bonds for recession, and then commodities for inflationary growth.

So, if you think about how that will compare to a typical 60% stock-40% bond portfolio, that 60-40 portfolio really has a lot of its risk associated with noninflationary growth. So, when you find yourself in a recession or a period where inflation starts to rise, those funds will tend to struggle a bit, and that's why we use those three major asset classes and have a very significant weighting in both bonds and commodities.

Leggio: So, one of the aspects of the strategy since you are managing different risk levels is you have to employ leverage to varying degrees. Can you talk a little bit about why the strategy requires leverage and then how you go about modifying the amount of leverage in the fund?

Wolle: Sure. So, if we start off with what would happen if you just try to balance the amount of risk of equities, bonds, and commodities, and that added up to 100%, you'd have a portfolio that would be about half of the risk of a typical 60-40 portfolio. And so to ensure that the returns are more consistent and competitive with those of a 60-40 portfolio, we use a little bit of leverage. Now the first questions are for how much leverage do you use, and how do you get that leverage?

We are using primarily exchange-traded futures to get our exposure, and so we had about $1.50 invested for every $1 in assets. But because we are using futures, we don't have any counterparty risk, and we don't have to borrow money from anyone to get that leverage. In fact, compared to the amount of collateral that we're told to own by the regulators for the portfolio, we have about 10 to 12 times that amount.

Leggio: So, one of the concerns of at least some of the critics that have written about these types of strategies is that they are very, very complex, and your funds are still relatively new. How do you answer some of the big concerns that you may have not only from analysts, but also investors as you try to explain this type of strategy to them?

Wolle: Well, there are couple of main streams to think about when you look at the complexity. First is, what is the experience of the team that's managing the portfolios? Really for most risk parity strategies, the teams have their history and managed money for institutional investors. So, this includes large pension plans, sovereign wealth funds, et cetera, and they also have a great deal of experience in managing derivatives. We have built systems to really be able to manage the kinds of risk that you have with the instruments that we use in the portfolios.

So, I think the first part is: Does the team have the experience and really the tools to be able to manage the portfolios? And then secondly, it gets into how much operational risk do you have in the portfolio? So, are you having to borrow money to generate the positions? What kind of counterparty risk do you have? And those are the areas we spent a great deal of time on to make sure that we minimize or eliminate those kinds of risks from the portfolio.

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Leggio: Sticking with the theme of risks, you've actually gone back since the strategies are relatively new to the 1970s, 1980s, and 1990s to see how your type of strategy would perform in different market environments. Can you talk a little bit about what market environments where your strategy would have some difficulty, but then also, where your strategy should probably perform the best?

Wolle: Great question. In some ways, you have to break that up in terms of where there are positive absolute returns and when you have relative returns that struggle. So, in terms of what kinds of environments the strategy might struggle in, we have three big asset classes. If two of those big asset classes are having a tough time at exactly the same moment, it's likely that the strategy will not have terribly attractive returns. Most of the time, however, when that happens, a typical 60-40 portfolio where investors currently have money would also be having a rough go of it. The times when the strategy does really, really well, often times would be at the latter parts recession when, a number of asset classes are doing well, and bond yields might rise, but not to a great degree.

We also think a great deal about what kinds of situations could this strategy struggle in, and one that a lot of people ask about are periods of rising interest rates, such as what happens with that. We've gone through a couple of those during our live period and have looked at those historically. Because the risk of bonds is just set right next to commodities and equities, with assets that tend to do better when interest rates are rising, the portfolio actually does pretty well.

Leggio: Great. One of the aspects of the strategies is that there is a fair amount of tactical positioning in the strategy. Can you talk a little bit about the need for that tactical aspect of the strategy? Specifically, we're talking now in early September, what those tactical strategies look like now, given 2% roughly 10-year Treasuries in a very volatile equity and commodity market?

Wolle: Great question. The tactical portion of the portfolio is very important. The thing that we tell investors is first of all, you have to get your strategic allocation right. So most of the risk in the portfolio is based on that strategic allocation, but the tactical allocation does help us navigate periods like we've just been through. So, where we find ourselves today relative to a month ago is we still have an overweight to government bonds, though, not nearly to the same degree that we did a month ago. We have a bit larger underweight to equities than we did before, and actually our commodity allocation has gone up slightly.

Leggio: The interesting thing about the strategy that you run is, even though it's a stand-alone mutual fund, you use this strategy for Invesco's target-date series. Can you talk about why Invesco chose to use this strategy--which is far different from most of the other target-date funds, which have static glide paths--and talk about some of the benefits but also issues that you face in and trying to combine those two types of strategies?

Wolle: We chose to take a very different path because we thought that the way that most target-date funds had been managed really had a couple of flaws in them. When you think about target-date funds, there are two things that you have to do. One is to manage how much risk you take, and the second is to decide where you're going to take that risk. Portfolio theory suggests that where you take that risk should stay constant over time. But what we fund in current target-date funds is that most of them really change their allocation as investors near retirement, from a very, very high weighing in equities, and in many cases even when they're about to retire, there's still about 50% weighting in equities.

What does that mean? Well, first of all, you're going to have a very high risk associated with outcomes other than noninflationary growth. So, if hit recession or periods of strongly rising inflation, those portfolios will probably perform very poorly, and there is no real defense against that. Our structure in contrast really still tries to balance how much risk we have associated with those different economic outcomes, and we keep that portfolio structure constant all throughout the life of the participant. But we do reduce the amount of risk. So we're keeping how the risk is allocated the same, but we're reducing the amount of risk that we take as we near retirement and where the participants won't have as much time to make up any losses.

Leggio: So specifically, with the glide path for the fund, can you talk a little bit about how that looks? Then specifically on the leverage component, which we talked about earlier, can you discuss how that looks as investors get to their retirement age?

Wolle: Great questions. The glide path is very, very straightforward. So from the period from about four years to retirement, up until 10 years to retirement, the fund has the same allocations, it's 100% invested in the balanced-risk-allocation fund. Once we hit 10 years away from retirement, then we start to reduce the amount of risk by adding money market funds, until we get to retirement which points of about 60% balanced-risk-allocation fund and 40% money market funds. At that point, the fund is effectively unlevered. So investors are just getting really a portfolio of stocks, bonds, and commodities that add up to 100%. That's about 5% annualized risk, which for a frame of reference is consistent with about 25% equity-75% bond portfolio.

Leggio: Well, Scott thanks so much for being with us today and describing the strategy.

Wolle: It's my pleasure. Thank you.

Leggio: Thank you for joining us. I'm Ryan Leggio for Morningstar.