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Impact Investing

IPE special report May 2018

Sections

Risk and Portfolio Construction: A new era for risk parity

Risk parity is the strategy that aims to be boring – managers use leverage not to deliver stellar returns but to increase the risk from lower-volatility assets such as bonds in order to spread risk equally across asset classes. The aim is to generate moderate, but relatively reliable returns for risk-averse investors.

In theory, such a strategy should avoid losses overall as the underlying asset classes ought to diversify one another, performing differently at any one time.

“In our Risk Parity Bond strategy, which invests in the sub-asset classes of government bonds, corporate bonds, inflation-linked bonds and emerging market currencies, we prefer to focus on correlations which are permanently changing in relation to each other,” as Torsten von Bartenwerffer, a senior fund manager at alternative investment firm Aquila Capital puts it. “The important thing is to seek out the asset classes which behave differently in certain economic and capital market conditions.”

But last summer even trying to be boring wasn’t enough to sidestep poor performance across multiple asset classes – bonds, equities and commodities all went south at once. With exposure to each of these markets, risk parity suffered.

“Last year was a year when diversification was not rewarded,” says Ed Peters, a partner at investment boutique First Quadrant, who highlights that inflation-linked bonds, emerging markets equities and real estate also contributed significantly to negative returns last year. “No multi-asset strategy did well. If you didn’t have large concentration in US and Japanese equities you didn’t do well either.”

The downturn in the bond market during 2013 appears to have attracted the most attention. By April 2014, 10-year US Treasury yields stood at 2.73%, up from 1.68% a year before. By the end of last summer they had already risen to 2.75%.

Comparable UK bond yields went from 1.66% to 2.72% and in Germany the 10-year yield went from 1.2% to 1.54%.

At a glance

• Risk parity strategies aim to exploit asset-class diversification in the most optimal way, chiefly by leveraging bond exposure.
• But what happens when bonds leave behind a 30-year bull market?
• Practitioners argue that rising bond yields do not necessarily pose a threat to the strategy – it all depends on whether yields rise faster than markets are already anticipating.
• And rising yields imply a healthy economy – and outperforming equities.
• While bouts of short-term downside correlation can occur, risk parity portfolios have tended to bounce back from them quickly in the past.
• Moreover, there is no rule that says bonds should be the leveraged asset in risk parity, or that these strategies should be managed ‘passively’.

“Bond yields have steadily declined over the last 30 years and this included the large drop that happened in the global financial crisis,” says Rita Gemelou, an investment strategist at BlackRock. “During May and June of last year interest rates spiked. If you take into account what happened in that period – the statements from the Fed, Bernanke talking about reducing quantitative easing – there was no formal increase of rates by the Fed, just the prospect of this increase in the future had a significant impact on the fixed income market.”

While it may be easy to hold Ben Bernanke solely responsible for the issues in the markets last summer, Peters says the Fed’s announcement in June that it would cut back its quantitative easing programme – since January this year the asset purchases have been cut from $85bn to $75bn a month – was not the only trigger.

“The tapering of QE mostly impacted the bond market,” he says. “We did not see much reaction from the US equities markets. The equity market started selling off later in May and into June when China said the economy was doing worse than expected. It was two separate events that just happened to coincide.”

Risk parity managers have expected interest rate rises for some time and acknowledge that the model has relied on low bond yields for years. However, they are adamant that risk parity will endure rising yields and adapt to market swings.

In September, BlackRock published a report that attempted to allay concerns about the issues faced by risk parity portfolios. Among other things, it pointed out that bondholders should continue to earn reasonable returns if bond yields rose gradually; only rate rises significantly faster and higher than expected should begin to erode bond returns.

To illustrate this, BlackRock considered three separate scenarios – rates rising by no more than 75 basis points more than expected; rates rising by more than 75 basis points more than expected; and rates falling.

BlackRock’s research showed that in the first scenario, risk parity strategies would return an average of 8.6%, an average of –0.3% in the second scenario and an average of 10.8% in the third. “All in all, the risk parity portfolio produces reasonable returns across different interest rate regimes – which is exactly what it was designed to do,” says the report. 

“There is a perception that if interest rates rise you will lose money on bonds and on the surface we can understand how that misperception exists,” says Bryan Belton, a director at PanAgora Asset Management. “But it is not entirely true.” 

When you decide to invest in bonds your decision should not be based on whether interest rates are going to rise, but rather on whether they are going to rise more or less than what is already priced into the market, he says. 

“If you look at the forward curve – the future expectation of interest rates – the market expects that the five-year yield in the US is going to increase by 70 basis points over the next 12 months and by 140 basis points over the next 24 months,” he says. “If the market’s expectations are right then you will not lose money by investing in bonds today. Your return will be equal to today’s current yield of the bond because current yield is simply the future cash flows of the bond discounted by the future expected interest rates. If interest rates in the future are higher than today – as the market expects they will be – then that is already priced into today’s valuations.”

So, holding interest rate risk is not so terrible as long as rates rise no faster than the forward curve implies. Furthermore, rising rates also imply fundamental things about the economy that will affect the rest of the portfolio. 

“If yields go up, equities will do well because the reason for rising yields is better economic growth or higher inflation,” adds Edward Qian, CIO and head of multi-asset research at PanAgora. “These create a natural hedge for a risk parity portfolio. That is why over the last 40 or 50 years there have been very few periods where all of these asset classes have provided a negative return. It happens once in a while like last May or June but they recover very quickly after that.”

Meanwhile, risk parity portfolios do not necessarily need to have such significant exposure to bonds. 

“Some of the critics say that risk parity is always concentrated in bonds,” says Hakan Kaya, a senior vice president at Neuberger Berman. “This is far from correct – it always depends on the situation, it depends on the market dynamics.  While in the last few decades more bonds were needed to equate stock risks, during the 1970s, bonds were riskier than stocks and a reasonable risk model would have suggested that in a risk parity portfolio, one should have held more stocks and commodities than bonds. Risk parity allocations are not static: they are episodic, economy-dependent.” 

Carolina Minio-Paluello, deputy global CIO of Lombard Odier Investment Managers, points out that managers should prepare for an environment where yields do not rise. “They could actually run the risk that they remain low for longer,” she says. “One way we are trying to protect from that is that in the bond portfolio, we are gradually reducing the allocation to bonds that are directional by replacing it with fixed income strategies which have much lower directionality.”

Risk parity can offer investors a buffer to unpredictable market movements but blindly allocating to asset classes irrespective of value should be avoided, according to Kirk Hartman, president and CIO of Wells Capital management. Rather, risk parity should be used as a guide, not an absolute. 

“Risk parity is a framework but it doesn’t substitute for judgement,” he says. “What is interesting about history is that it repeats itself but not in the same patterns. [When there] is a spike in volatility correlations [can] go to 1.0 and can throw historic metrics out the window. Risk parity models will point to certain asset classes and in an ideal world tell you where to be but you also need to overlay with judgement. That is the value-add of an active manager.”

Paul Sweeting, European head of the strategy group at JPMorgan Asset Management, agrees. 

“Using a risk parity approach implicitly assumes that you get an equal premium per unit of risk whatever asset class you are looking at,” he says. “However, it is possible to adjust the risk parity portfolio by altering this premium to reflect beliefs about returns. If this is taken too far, then a portfolio can end up looking nothing like a risk parity portfolio and ignoring all of the insights that risk parity provides. But if an investor’s views of risk premiums are combined with the confidence in those views – with zero confidence meaning that the risk premium defaults back to that implied by risk parity – then views on extreme valuations can be taken into account.”

Michael Mendelson, a principal at AQR Capital Management, points out that 2013 was difficult for risk parity relative to traditional allocations, which are usually equity risk concentrated, because one market risk did well – equities – and the others didn’t.

“In 2013, risk levels were low — most of the time,” he says. “In the second half of the second quarter, risk levels for some asset classes rose, leading us to reduce our exposure levels for a period of time in an effort to maintain a steady level of portfolio risk. In versions of our strategy where we express views on expected return, we were generally tilted toward stocks and away from bonds throughout the year. However, in all versions of our strategy, the risk we allocate to tactical views is small relative to the risk we allocate to the strategic component of risk parity.”

Kurt Winkelmann, head of risk and analytical research at MSCI, says risk parity managers are increasingly introducing dynamic elements to their portfolios – something he points out has not previously been particularly necessary. 

“My impression is [investors] do not really want to maintain a static portfolio mix,” he says. “Then the product development challenge is how do you make a more dynamic asset mix yet at the same time retain the rules-based philosophy that underlies the original risk parity model?”

Furthermore, investors in risk parity continue to demand a greater level of sophistication and risk analysis from their managers. Firms are now more likely to use risk models to design the structure of a risk parity portfolio, and attribution analysis to work out which factors are driving risk, according to Winkelmann.

“What we see now is much more of an appetite for having a deeper understanding of the sources of risk on a forward-looking basis, not past,” he says. “With that deeper understanding, we can figure out how to introduce more dynamic elements in the portfolio construction process.”

Franck Nicolas, head of investment and client solutions at Natixis Asset Management, says that forward-looking measures of implied volatility from options markets can help in adjusting algorithms for calibrating portfolio risk, for example. Gemelou at BlackRock emphasies a fundamental understanding of what is driving the factors to which her portfolios have exposure – economic growth, credit, emerging markets, inflation risk, liquidity risk. 

“Having said that, the allocation doesn’t change on a day-to-day basis or a weekly basis,” she says. “It is a strategic asset allocation which is market aware. We take into account the valuations, risk sentiment, volatility in the market to decide whether we need to tilt the portfolio to protect returns, or take advantage of pricing anomalies.”

Winkelmann says deeper analysis could help risk parity firms differentiate themselves in a challenging market: “If you look at today’s investing environment there is a lot of short-term and long-term uncertainty. It gives the end investors – pension funds, sovereign wealth funds – a very strong incentive to try and understand these underlying sources of risk. That is the demand side. On the supply side, for many firms, particularly those who have had a rich history in using risk models to structure and understand portfolios and communicate with their clients, it gives them a competitive edge.” 

While risk parity might be aiming for a boring risk and return profile, its changing prospects in world of rising bond yields and lower returns for greater risk – and the tactics it is adopting to meet those challenges – are anything but.

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