Asset Allocation: Matters of perspective
There is still a role for risk parity strategies, finds Emma Cusworth, provided pension funds take a long-term view
At a glance
• Risk parity has underperformed a traditional 60/40 approach in recent years.
• They are not the ‘all weather’ funds many had expected them to be.
• The diversification benefits mean it still has a place, as long as investors are willing to ride out periods of underperformance.
The performance of risk parity funds over the past two years has been disappointing for many investors. Having navigated the choppy waters of 2008 relatively well, these strategies became popular. However, as performance has faltered, their role has come into question. They are not the all-weather funds many had expected them to be. Nevertheless, because of the considerable uncertainty about the future direction of interest rates and the lack of ability to forecast, risk parity still seems to have a place in institutional portfolios.
Risk parity has gained favour since the financial crisis. Bridgewater’s All Weather strategy, where the approach originated, reportedly had roughly $70bn (€63bn) in assets under management in early April, while the industry as a whole is estimated to be worth up to $600bn. According to the consultancy Bfinance, these strategies account for about 10-20% of manager searches in the multi-asset universe.
However, more recent years have been less favourable for the strategy and performance has lagged more traditional balanced allocation approaches. “Between 2009 and 2014, equities, commodities and bonds were very strong and risk parity funds did really well,” notes Mercer partner Nick Sykes. “That was an unusual period. There was a splurge of returns, but these funds have given quite a bit back since then.”
Over the three years to end-March 2016, for example, BlackRock’s Market Advantage (Risk Parity) strategy returned 2.09% annualised in dollar terms, compared with 4.70% annualised over five years and -4.98% over the preceding 12 months (see figure).
For AQR’s $519m (€466m) Risk Parity fund, annualised total returns over three and five years for class I shares to end-March were -0.4% and 3.93%. The fund returned -7.81% over the preceding 12 months. Bridgewater’s All Weather strategy reportedly fell 7.7% last year.
“In general, risk parity returns have been a bit disappointing in recent times, particularly in comparison to a 60/40 capital allocation approach,” says Chris Stevens, senior associate in Bfinance’s diversifying strategies team.
The relative decline in returns from risk parity has raised questions about whether investors fully understand the purpose of the strategy. As the name of Bridgewater’s strategy would suggest, risk parity was expected by many to perform whatever stage the market cycle was in. That has not proven to be the case.
“Some people still think risk parity is an all-weather approach, but in reality it is not,” says David Hutchins, head of AllianceBernstein’s multi-asset pension strategies in the UK. “Things rarely do as expected,” he continues. “People say they understand, but are still disappointed when performance is not what it was in the past. People have bought risk parity in the last five years based on how well it did in 2008, but most of that stuff has disappointed since.”
The basic premise of risk parity is that it is a “robust way to diversify”, as Florence Barjou, head of multi-asset investments at Lyxor Asset Management describes it. “It is meant to bring diversification over the long term,” she says.
As in 2008, losses in one part of the portfolio should – in theory at least – be offset by gains in another. Recent years have not been so accommodating, however. In 2013, for example, the taper tantrum caused simultaneous losses across many of the underlying asset classes. Barjou says: “The strategy did not work, but that was not because diversification wasn’t paying off. All the underlying assets suffered losses for long periods of the year from April onwards.”
In 2015, as commodities fell 27%, there was no increase in government bonds to offset those losses – even after leverage – as there has been historically, which weighed heavily on risk parity strategies.
“On average, the worst thing for risk parity is when everything falls at the same time,” says Michael Mendelson, principal at AQR Capital Management. “It is important to understand that risk parity can underperform other allocation methods for extended periods. The strategy offers a modest long-term edge over traditional allocation and lots of diversification, but to reap those benefits investors have to either stick with it for the long term or be able to forecast its periods of outperformance or underperformance with a precision often claimed but rarely realised.”
Predicting periods of outperformance or underperformance is harder than many would think. A study by AQR into the forecasting ability of economists regarding interest rates shows estimates given at the start of a year of where 10-year yield levels would be at the end of that year are routinely overly pessimistic. Furthermore, since the financial crisis, the ability to forecast has worsened markedly, with both the degree of error and the difference between top and bottom estimates increasing.
“Three years ago investors began asking us how the strategy would perform in an environment of rising interest rates,” Mendelson says. “That still hasn’t happened.”
AQR’s 2013 study ‘Can Risk Parity Outperform If Yields Rise?’ found these strategies can outperform traditional asset allocation in a moderately-rising-rate environment. However, if rates rise sharply in a short period, risk parity is more vulnerable than traditional approaches. However, the outcome is far from certain.
Mendelson says: “Rising rates can be a headwind for equities and traditional allocations. Are rates going up because of inflation, which may be negative for stocks, or because the economy is stronger and central bank policy is changing, which may be good for stocks?”
Equities also look expensive, which suggests prices could struggle to gather further upward momentum. “Quantitative easing brought forward all the returns you’re going to get, so people would spend their money,” says AllianceBernstein’s Hutchins. “Outperformance over the next five years will only happen where there is genuine skill, which is the same for all asset allocation approaches. Passively allocating to simple beta returns won’t get you anywhere.”
And increases in interest rates are far from guaranteed. As rates hit zero, markets appeared to assume they could only rise from there. But markets have continued to fall into negative territory and can still go lower, and remain so for longer.
According to Raphael Sobotka, global head of multi-asset for institutional clients at Amundi, the risk remains to the downside. “Interest rates will be contained as we’re still in a significant savings-glut environment that will put pressure on rates for a long time.”
“The truth is there is no knowing where rates are going to go,” AQR’s Mendelson says.
Yet, despite an uncertain performance outlook, the current environment is arguably one in which allocations to risk parity strategies make the most sense. The basic premise of diversification is to protect portfolios from the unknown as different assets pay off at different times and returns tend to be in proportion to the risk taken.
“If you know where markets are going, risk parity is not for you,” says Mendelson. “You’d just buy what’s going to go up. But those that are more realistic about their forecasting power, need to be diversified. Risk parity is appropriate for those with some modesty of views.”
This cycle is also unpredictable and what worked in the past cannot necessarily be relied upon to do so this time around.
“Rising rates would typically be negative for bonds but, at the same time, strong growth is supportive of equity and credit,” says Sykes. “That’s how it’s worked in the past, but who can say with this cycle? We don’t know how it’s going to pan out. There are no signs of excessive growth or inflation, which would usually be signs for interest rates to rise.”
Importantly, given the lack of ability to forecast markets effectively, trying to time allocations to the strategy is beyond difficult and, according to Stevens, “tends to lead to performance chasing” as investors trade in and out on the basis of past performance.
As Sykes concludes: “Either take the long-term view that the strategy will capture returns in the long term, or don’t do it at all.”