Risk parity became popular following the bloodbath brought on by the credit crunch as investors sought to protect themselves from extreme volatility. But does the strategy still have a role to play? Lynn Strongin Dodds finds out.
“Leverage is one of the biggest issues. Pension funds are fine when it is embedded, as with hedge funds or property, but they are averse when it is at the top total fund level.”
Mirko Cardinale
Risk parity is not a new concept, having come onto the US investment scene in the 1960s, but gained a new lease of life following the credit crunch when all asset classes were in freefall. Investors were looking for downside protection and a different way to construct portfolios. Fast forward to today and although its popularity has waned, risk parity still has a place in the toolkit.
“To put it into context, risk parity is one of the many flavours in the market,” says Piera Elisa Grassi, portfolio manager in the firm’s research-enhanced index team. “After the financial crisis it became relevant and was in demand because we were coming out of a period of high volatility and market distortion. Risk parity can be appealing once you have suffered losses but there has been an evolution to a more refined way of building equity exposure.”
It was originally devised as an alternative to the traditional 60% equities and 40% bonds portfolio. The theory is that having balanced exposures to three main asset classes can produce more consistent and better risk-adjusted returns over the long term because it aims to lessen the impact from individual asset classes in different market conditions. Normally, equities do well in high growth and low inflation environments while bonds shine in deflationary or recessionary backdrops and commodities often perform best during inflationary conditions.
GAINING LEVERAGE
One of the main criticisms is the use of credit to increase the risk and return contribution of low volatility/low returning assets.
“Leverage is one of the biggest issues,” says Mirko Cardinale, head of asset allocation for EMEA at Russell Investments. “Pension funds are fine when it is embedded within funds as it happens with hedge funds or property, but they are averse when it is at the top total fund level. This does not mean that they will not allocate to risk parity funds, but that they are unlikely to embrace risk parity as a total portfolio solution.”
Confidence can also be shaken if interest rates rise which as signalled by Federal Reserve chair Janet Yellen is expected to occur in the US at the end of the year. Research has shown that this could have a detrimental impact. For example, a 2012 study undertaken by Clifford Asness, founder and managing principal, Lasse Pedersen, principal and Andrea Frazzini, principal of AQR Capital Management found that the strategy was almost flat from 1962 to 1986, while a traditional asset allocation portfolio turned in a strong performance during a high rate environment.
Comments