These results are echoed in a more recent report published last year by Emanuel Derman and Mengyao Lu of hedge fund KKR Prisma which ran 1,000 different scenarios for commodities, equity markets and bond yields over the next 10 years. They showed that a typical risk parity portfolio would only outperform a 60/40 strategy if interest rates remain low and commodity returns are high.
THE COST OF BORROWING
The pain might be even worse for those using leverage due to higher borrowing costs. Just the mere hint in 2013 of an increase sent institutions running for the door. Figures from Morningstar showed that stalwarts such as Bridgewater’s All Weather fund slid 4.6% across the whole of 2013 while Salient’s Risk Parity fund dropped 4.58%. AQR just eked in a positive 0.12% during the period while Putnam’s Dynamic Risk Allocation fund grew by 3.99%. By comparison, the FTSE World index returned 22.36% over the same period and the average return from the FE Global Bond fund sector was -1.96% for the year as a whole.
The funds that fared the best were the ones like Putnam that had the flexibility to make tactical shifts like cutting bond exposures, although this did dent the claim of risk parity providers that it is a relatively inexpensive passive, quantitative strategy. Many of the leading lights such as AQR, Bridgewater and Invesco though rebounded strongly in 2014, reinforcing the argument that risk parity needs to be viewed over a long time horizon.
In fact, research from Alliance Bernstein shows that over the past 100 years, periods of sharp sell-offs in bonds or commodities have typically led to strong performance for risk parity strategies. They can lag behind a 60/40 approach over any short period of time, particularly when equities are booming but the advantage from the classic balanced fund approach is unlikely to last. Its study revealed that over five-year or 10-year periods, risk parity outperformed its 60/40 predecessor more than 70% of the time. In addition, its performance was not only higher but also more consistent.
GROWING INTEREST
Proponents also argue that the pace of rate hikes will be slower and that funds will have time to adjust.
“When considering a rise in interest rates, one needs to distinguish between a gradual, long-term rise in interest rates and a market-driven interest rate shock,” says Dr Torsten von Bartenwerffer, head of strategies and portfolio management at Aquila Capital. “A gradual, long-term rise does not pose a threat to a risk parity strategy since a slow change in interest rate levels can be managed well with a risk parity based asset allocation and the consequent volatility adjustment in the individual asset classes. A market-driven interest rate shock is more of a concern. This occurred in 2013, when the Federal Reserve announced its intention to roll back its quantitative easing programme.”
To mitigate these risks, Aquila expanded its risk management system within its offering to strengthen its resilience to scenarios seen in 2013, according to von Bartenwerffer. The new tool “builds on downside volatility, recognises correlation spikes early on and responds with a timely and drastic reduction in risk,” he says. “We believe that our risk parity strategy is well equipped to withstand similar market conditions to those seen two years ago.”
Bryan Belton, director, PanAgora Multi-Asset Group, also notes: “There is a fear of rising rates in the market but when we create a risk parity portfolio, we structure it to ensure that the influence of equities is similar to that of bonds. In other words, the losses from bonds will be offset from the return contributions from equities. The aim is to create stability across economic shocks and to diversify across asset classes that respond and re-price differently to market conditions.
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