The “risk parity” concept has been among the most popular ideas in fund management and asset allocation over the past few years, and has been one of the keys to the extraordinary success of Bridgewater, one of the most highly regarded hedge fund firms. Although the idea has never really made sense to me, I figured that the rocket scientists at Bridgewater, AQR and the like must have a handle on the obvious pitfall. According to an article in today’s Wall Street Journal (ht Barry Ritholtz), that may have been too generous an assumption.
Risk parity sounds eminently rational. You begin with a portfolio that is diversified across markets like bonds, stocks, emerging markets, real estate, etc. But where a traditional asset allocation portfolio would simply take the returns and volatility of this portfolio as a given, risk parity goes one step beyond this to engineer a targeted risk profile. It does this by using leverage/hedging to adjust the volatility of each of the asset classes in the portfolio so that they are equal (hence the “parity”). Theoretically, this should allow the fund manager to engineer a target level of risk while still getting the benefit of diversifying across different markets.
In practice, what this has meant is that bonds – which tend to have the lowest volatility of the major asset classes over time – are leveraged so that their volatility is magnified. That’s a great strategy when things are going well, and it’s also a great answer to the need for greater returns – it allows you to hold bonds in your portfolio, but it also lets you get more juice from them. In normal times, it should also protect your portfolio from falling equity markets, since bonds (and particularly Treasuries) tend to do well then.
Unfortunately for risk parity funds, however, leverage works in both directions. When bond markets are not doing well, this all but ensures that you have leveraged exposure exactly where you don’t want it. Worse still, these are not normal times – in the strange markets of 2013, both equities and bonds have been falling together. The results, according to the Journal article, have not been pretty:
The recent market turmoil has tested many followers of the strategy. That is mostly because stocks have tumbled along with bonds after the Federal Reserve hinted at a reduction in its stimulus program last month. Making things worse, commodities and inflation-protected securities, which are widely used by risk-parity managers as a hedge against inflation, also suffered heavy losses because of receding inflationary expectations.
“We don’t expect to make money every year,” said Bob Prince, co-chief investment officer of Bridgewater, which regards itself as a pioneer of risk parity. Bridgewater’s $75 billion “All Weather” risk-parity fund is down about 8% for the year, according to a person familiar with the returns.
Risk–parity mutual funds have lost an average of 6.75% this year, according to Morningstar. Meantime, a stock-and-bond index comprising 60% of the S&P 500 stock index and 40% of the Barclays U.S. Aggregate Bond Index, a widely used bond benchmark, is up 6.76% this year, according to Morningstar. Risk-parity proponents often argue that their strategy is designed to beat a so-called 60/40 portfolio of stocks to bonds.
I think risk parity is particularly interesting in terms of the power of branding. In spite of this gap in the strategy’s logic, the idea of these as “all-weather” portfolios (Bridgewater went so far as to name its funds that) has taken hold first with institutions, and more recently with retail investors. And the biggest gap of all comes in the perception by many that these are defensive strategies, regardless of the fact that using leverage on bonds is the opposite of defensive.
For a sense of the difference between perception and reality, consider the investor’s perspective:
Many of risk parity’s followers have been counting on the strategy to generate solid returns under almost any circumstance, particularly in rocky markets such as the current one.
“Investors have come to view these as really defensive types of vehicles, so expectations are being disappointed,” said Josh Charlson, a senior mutual-fund analyst at Morningstar.
And compare that to the fund manager’s view:
“There are going to be environments where it massively outperforms and there are going to be environments like the last couple of months where it underperforms,” said Michael Mendelson, a principal at AQR who is a portfolio manager for the hedge-fund firm’s risk-parity strategies. “It’s going to go both ways,” he said, adding that risk-parity should outperform a traditional portfolio over the long-term.
I have a feeling a lot of investors are wishing they had heard the latter story rather than the former. They would have been much better served if they had.