The financial crisis may have sent institutional investors scurrying to find a substitute for the holy grail of modern portfolio theory, but breaking its hold has not been easy. While risk-based approaches have generated a great deal of buzz, the latest set of figures show the most popular strategies have underperformed, which is why the underlying methodologies need to be carefully examined.
“In the past risk parity was seen as mainly an academic and research-driven subject, but in the past two-to-three years we are seeing investors much more interested in using it as a way to build portfolios.”
Thierry Roncali
The most disappointing results emanated from risk parity mutual funds which had become one of the investment darlings in the US over the past five years. Data from research firm Morningstar showed they lost an average of 6.75% in the first half of the year, which is a marked contrast to the rise enjoyed by the so-called 60/40 portfolio of stocks to bonds which the strategy is designed to beat. For example, this portfolio split between the S&P 500 stock index and Barclays US Aggregate Bond index, a widely used bond benchmark, enjoyed a 6.76% hike over the same timeframe.
The underperformance was a surprise because one of the main selling points of risk parity is its all-weather nature. In other words, returns can be generated in most environments by equally distributing risks among asset classes. This typically means equities which tend to do well in high growth and low inflation environments as well as bonds to offset deflationary or recessionary backdrops. Commodities are often added to the mix because they perform best during inflationary conditions.
The main criticism is the use of leverage, which attempts to enhance the bond portion in order to closely match the performance profile of equities. One of the dangers highlighted in a recent JP Morgan Asset Management report entitled, Diversification: Still the Only Free Lunch? is if interest rates rise. The fund management group noted that this has become a major concern today given the increasingly vulnerable point in the interest rate cycle. The other weakness is that risk parity presumes different asset classes are uncorrelated or have low correlations. In reality, seemingly diverse asset classes can be unexpectedly close because they share common underlying risk factor exposures.
This is exactly what happened when the Federal Reserve signalled that the end was nigh – 2014 – for quantitative easing. The news in mid-June sent a shudder across stock markets around the world and prices tumbled in tandem. The Dow Jones dropped 2.3% while the FTSE 100 fell by 2.98%, the steepest decline since 2011. Across the Channel, Spain’s Ibex skidded by 2.9% with German, French and Italian markets all sliding by more than 3%. Matters for risk parity followers were further compounded by commodities and inflation-protected securities, which are widely used by risk parity managers as a hedge against inflation, suffering heavy losses due to receding inflationary expectations.
Events took their toll and US investors pulled around $20bn in June from mutual funds and exchange traded funds including risk parity although numbers were not broken down by asset type. While this is unlikely to sound the death knell for the approach, it may slow down inflows which climbed to record heights of $15.1bn by the end of May, up from $73.6m at the end of 2008. Some analysts believe there is as much as $200bn in total risk parity strategies.
Europeans though have always been more reticent about risk parity with estimates showing there is roughly £2bn of assets under management in the UK. Change will be slow, according to a recent survey conducted by alternative manager Aquila Capital which canvassed 225 institutional investors in the country as well as the Netherlands, Scandinavia, Germany, and other large European countries. Only a third said they were familiar with the concept while 50% would consider an allocation. For those that did have an exposure, it was less than 5% of the overall portfolio.
“Investors in the UK and Europe are nibbling away at the world of risk premia, but they are still mainly using traditional asset based tools to create portfolios,” says Divyesh Hindocha, Mercer Investments’ global director of consulting. “Risk parity is one simple approach to capturing a diverse set of risk premia, however it is seen more as a product than a fundamentally different way to construct a portfolio. One of the challenges of a true capture of the risk premia approach is comfort with, say, leverage. The packaging around risk parity can be helpful in addressing this issue.”
Thierry Roncali, head of research and development at Lyxor Asset Management, disagrees, noting there is more interest being generated. “In the past risk parity was seen as mainly an academic and research driven subject, but in the past two-to-three years we are seeing investors much more interested in using it as a way to build portfolios.”
The new generation
In fact, asset management firms in both regions have been honing their offerings as well as developing a new generation of risk based products in an attempt to attract clients. One of the problems is building a risk parity portfolio is not that simple because there are many different ways to do it,” says Roncali. “For example, we look at the macroeconomic picture such as inflation, interest rates and growth, risk premia and then asset allocation. One of the biggest challenges is how to incorporate your views of expected returns into a portfolio.”
Paul Sweeting, European head of strategy at JP Morgan Asset Management, believes UK and European investors are also still concerned about price movements and the leverage used in standard risk parity portfolios. The asset management group is trying to counter these views with its own approach – factor risk parity whereby asset classes are broken down into building blocks, or factors, that explain the majority of their risk and return characteristics. It also employs a new tool – the forecast hedge – which regulates the amount of uncertainty in forecasts and weights risk parity and traditional asset allocations accordingly.
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