3 Reasons to Rethink Risk Parity
Seeking to justly capitalize on Modern Portfolio Theory (MPT), risk parity uses the power of leverage to form a diversified portfolio that can generate equity-like returns with using less risk than equities. This alchemist-like strategy aims to construct a well-diversified portfolio that has the highest probability of outperforming cash. At formation, a risk parity portfolio has a low expected risk and return profile; however, investors can apply leverage to achieve the desired risk profile. Interestingly, risk parity breaks norms in not using asset class return forecasts to build a portfolio; it uses risk estimates to size positions within the portfolio. Sounds good?
Risk parity has attracted many adopters on the institutional investor side. Some asset owner converts include Denmark’s ATP, Ontario Teachers’ Pension Plan (OTPP), Healthcare of Ontario Pension Plan, Indiana Public Retirement System, State of Wisconsin Investment Board (SWIB) and the Teacher Retirement System of Texas (TRS). In October 2012, TRS invested US$ 584 million in risk parity strategies, awarding it to two external managers, Bridgewater Associates and AQR Capital Management. The Texas pension giant and SWIB developed their own internal risk parity strategy. Some institutional investors find it harder to use external money managers for risk parity due to overlay and control issues.
With that being said, a lot of money managers have been getting into the risk parity business. Some of the heavyweights in risk parity are AQR, Invesco and Bridgewater Associates.
In the last twelve months, risk parity strategies have performed poorly. UK-based investment consulting firm Redington said risk parity lost 5.4% for the year ending June 30th, while U.S. equities and other developed equity markets had positive returns.
Here are 3 reasons why risk parity could be dangerous for an institutional portfolio.
#1.) Massively Underperform in Periods of Rising Interest Rates
How risky are bonds in a prolonged period of zero interest rate policy? Typical risk parity strategies have allocations to nominal bonds which can expect to be pummeled on if interest rates rise faster than expected. In May 2013, the month of the “taper talk”, many risk parity strategies underperformed, seeing fund returns plummet in mid-single digits in a matter of weeks. The interest rate shock of 2013, exposed the sensitivity of risk parity strategies. Ray Dalio’s Bridgewater, known as the godfather of risk parity, had a tough June 2015 month. Bridgewater’s All Weather fund returned -3.78% in the month according to Forbes. Invesco Balanced-Risk Allocation Fund, looking at net asset value, from June 30th, till the beginning of the year netted 0.35%. MSCI World Index posted 2.95% comparing the same period.
|Risk Parity Funds and Strategies||2014 Return||S&P 500 Price Return USD||Excess Return|
|Bridgewater All Weather Strategy||8.6%||13.69%||-5.09%|
|AQR Global Risk Premium Fund||9.4%||13.69%||-4.29%|
|Invesco Balanced-Risk Allocation Fund||5.5%||13.69%||-8.19%|
|Salient Risk Parity Fund||13.58%||13.69%||-0.11%|
|Putnam Dynamic Risk Allocation||2.69%||13.69%||-11.00%|
Source: Morningstar, Forbes, Invesco, AQR
#2.) When All Asset Values Drop, You Are Still Screwed
Risk parity assumes risk and volatility are related. Like in 2013, when many asset classes fell, the diversified approach failed, leaving nowhere to hide but in cash. Risk parity strategies are short cash, leading to poor performance when cash is king. When markets lose confidence like in 2008, where there was a flight to quality, risk parity would have performed negatively.
#3.) Using Leverage to Reduce Risk
This notion of using leverage to reduce risk makes sense in some scenarios. However, there needs to be sufficient cash in the portfolio to meet margin calls, proper counterparty risk control, true diversification and having a level of asset liquidity. These sophisticated techniques come at a price. Institutional investors when externally allocating are paying big for the modeling and strategic diversification. Varied manager statistical models will yield different answers, thus some managers are able to draw in more clients due to their ability to generate higher returns due to more accurate models.
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