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April 1, 2015

Are risk parity funds worth a look?

The big draw-downs in the equity markets in 2008 were a wake-up call for investors to find alternative investments that offer similar returns but lower risk. The financial industry has launched so-called risk parity funds as a potential solution. Risk parity strategies have become very popular, especially among institutional investors, because of past strong performance and impeccable backtests. Risk parity strategies clearly have some decent theoretical underpinnings. Should private investors also jump on the risk parity band-wagon or is it just the financial industry’s latest attempt at another mousetrap?

What is risk parity?

The institutional pioneer was hedge-fund firm Bridgewater Associates, which launched its All Weather risk parity fund in 1996. A traditional balanced mutual fund might allocate 60 % of its assets to stocks to capture market appreciation and 40% to bonds to provide income and a cushion for market dips. The argument against traditional balanced funds is that, because stocks are more volatile than bonds, overall such funds are riskier than investors realize. Risk parity funds, on the other hand, allocate their money based not on asset classes but on risk.

Let’s talk about the recent performance

This is where the picture gets less clear. The performance of risk parity funds over the last three years was not as good as it used to be historically. More worringly, in 2013, most risk parity funds reported serious losses while a traditional 60/40 balanced portfolio would have delivered a solid positive performance. 2013 revealed several interesting aspects about the risk parity strategy:

  • They do not always exhibit less volatility than equities. For example the AQR Risk Parity Fund (one of the largest funds) lost 13% from May 9th to June 24th („taper tantrum“) and fared worse than US shares, credit or treasuries
  • There is in fact not one risk parity strategy. Though the asset managers use similar terms, the approach can differ meaningfully. Therefore, fund selection requires a great deal of due diligence. As 2013 showed, the distribution of results can be pretty wide. Interestingly, the same thing happened in 2008, when the biggest and most famous risk parity fund of all, Bridgewater’s All Weather, lost 25% while others showed solid gains. Given the black-box nature of most risk parity funds, it is hard to tell from the outset how they will behave in a given market environment. Let’s just call it risk disparity?

Is risk parity more fair weather than all weather?

This is where it gets really interesting. The strong historical performance of risk parity since the 90s has co-incided with three market environments that may not continue going forward:*

  • Falling treasury yields. Risk parity funds overweight (and usually leverage up) the fixed income portion of the portfolio. The last 20-30 years were the perfect environment for this as treasury yields went downhill nearly in a straight line. However, we have now reached a level below 2% for the US 10 year treasury and there is not much more room for a decline. German 10y Bunds yield only 0.2% which begs the question how much you need to leverage near-0% bonds to get any meaningful return?
  • Stable and low correlations. Risk parity works best when the correlation between different asset classes remains relatively stable and low. As 2013 has shown, this is not necessariy always the case. In Q2 2013, bonds, equities and commodities all dropped at the same time. In addition, risk parity benefited from the negative correlation between equities and bonds after 1998. However, this is not a given, as the correlation was in fact positive in the 30 yers prior. A regime shift in the correlation paradigm could lead to serious losses for risk parity funds.
  • Liquid markets. Risk parity funds are built on the assumption that leverage, especially implicit leverage of futures, does not materially increase the liquidity risk of one’s portfolio. In the new world of tighter regulation where banks can hold fewer trading assets (Dodd-Frank), this could turn out to be an unrealistic assumption. Risk parity strategies were only a tiny part of the market when they were first set-up. Today, it is estimated that more than $500bn AUM are in various risk parity strategies. If all risk parity funds are trying to rebalance at the same time, there is a risk of liquidity drying up which would lead to an adverse jump in prices.

Back to basics

Investing is about managing risk and returns. Risk Parity strategies however target volatility with the implied assumption that this is the same as risk and that it has a direct relationship to returns over the long-term.  We would question both of these assumptions.

Let’s be clear, low volatillity is not the same as low risk. But risk parity classifies low volatility assets as low risk, even when they are at record high prices. Risk is surely a function of the price you pay. Risk is therefore about the permanent impairment of capital, not how volatile an asset class is.

According to risk parity proponents, volatility = risk = direct relationship to return over the long term. According to the textbook, this is true. But in reality most risk parity funds have been unable to prove that relationship.

Risk Parity funds obsess over volatility and often give volatility targets to differentiate their funds. However, investors’ financial objectives are typically more complex than achieving volatility levels. Put bluntly: is volatility really the primary risk an indiviudal investor is looking to manage?

Summary

Risk parity is not immune from drawdowns, nor is it a guarantee of low-volatility returns, nor is it always uncorrelated to a traditional 60/40 mutual fund. Investors must understand that risk parity is still risky. It may not have equity-type risk, but it carries other risks nonetheless. Make sure you understand those.

We investors are often guilty of fighting the last investment war (in this case fears about a repeat of 2008) and are all too willing to buy into a new mousetrap with very short track records. For better or worse, early investors will be guinea pigs. At the very least, investors need to understand the underpinnings of the risk parity strategy, i.e. in which environment it performs and when it is likely to deliver losses. Don’t risk poverty on risk parity.

Let’s be realistic: risk parity funds have a decent theoretical underpinning but they are complex. One way their managers equalize risk across asset classes is through the use of leverage and derivatives. Risk parity are based on the assumption that risk (i.e. covariance) forecasts are more reliable than return forecasts. If you can’t define these terms, you are probably not ready to invest in these funds.

A good financial advisor can be a big help in evaluating risk parity funds. But many advisors don’t necessarily understand these complex products either. Worse yet, some are financially conflicted – they will talk up a certain fund because they stand to earn a fat sales commission.

That brings us to the final point, one we keep obsessing about in this low-return environment. Costs matter a lot. In theory, risk parity funds could be a great low-cost investment product because they trade in highly liquid futures and often have rules-based implementations, thus avoiding some of the high costs associated with active management. In reality though, most risk parity funds that are available to individual investors come with high fees. In a world where future returns are likely going to be lower than most people expect, the fee story becomes a glaring part of the equation.

 

* Why will future returns of risk parity strategies likely fall short of those of the last 20 years? As has been shown, risk parity funds did not perform well in the latter years of the last decade, as the Fed’s hiking cycle raised the discount rate. Now we are entering another Fed rate cycle and history is probably going to repeat itself. We can plot the 5y change in the 10y TIPS real yield with a  3y lag (as the discount rate works itself through the financial system) against a simple risk parity strategy of SP500 and long bond futures – we can then observe that a rise in the discount rate (TIPS real yield) has been a good leading indicator for mediocre risk parity returns.

RP

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