Risk parity strategies have confounded the sceptics in 2017, performing well following mixed performance in previous years. This year, a tail wind in equity markets and commodities has boosted risk parity, while stable rates at the long end of the US curve mean bonds have contributed too.
Transparency in risk parity is also increasing with the launch earlier this year of HFR’s dedicated index series. Better information on risk parity will doubtless help bring the strategy to a wider audience. But as James Price of Willis Towers Watson argues, investors really need to buy in to the principle of risk-based portfolio construction before they embrace the concept.
A persistent concern of risk parity strategies has been that they will not be able to withstand rising rates, as a BlackRock paper on risk parity from earlier in 2017 acknowledges. In fact, the real concern for risk parity is if rates rise faster than the market has priced in, and it is worth taking into account that most investment portfolios will be sensitive to the risk of rising rates and higher volatility anyway. If GDP rises ahead of interest rates, the overall picture is benign, as Bob Prince, co-CIO of Bridgewater outlines in an interview in this report.
For Bridgewater, the issue is the influence on cash flows; most asset classes can be understood in terms of their exposure to growth, inflation, discount rates and risk premia. “That’s really all there is,” as Prince tells IPE. Investors should also understand that the driver behind bond returns is the premium above the risk-free rate, not the bond coupon or return per se.
Prince remains adamant that investors can apply the underlying principles of risk parity themselves. Some, like Denmark’s ATP, will be intrepid enough to do this on their own.
While they may or may not wish to do that, increasing awareness of risk premia and market risk factors generally in recent years has certainly diminished the mystique around hedge funds. It has also prompted some investors to embrace what have become known as alternative risk premia strategies. For others, particularly smaller investors, diversified growth and target return funds remain an important way to diversify their portfolios and reduce volatility.
As strategies evolve, the boundaries between the categories often start to erode so taxonomy becomes less important as robust assessment of the underlying drivers of each strategy gains in significance.
As they assess asset class returns and risks, investment committees must weigh central bank actions, low yields, tight credit spreads, potentially stretched equity valuations and lower future real returns, not to mention the growing issue of political risk.
Many are likely to conclude that some form of multi-asset strategy will help them meet their long-term goals as they seek to embed asset allocation skill in their portfolios. What they are prepared to pay for this skill, however, is another matter entirely.
Liam Kennedy, Editor, IPE
Risk parity: Renewed vigour
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Risk parity: Renewed vigour