Risk & Portfolio Construction: The only way is up?
Jennifer Bollen looks into what rising bond yields would mean for risk-parity portfolios
Risk parity is increasingly attracting the attention of investors worried about
continuing market volatility. In December 2012, a survey of European investors by Aquila Capital showed that half of those familiar with risk parity, but not yet invested in the strategy, would consider it.
In March, IPE reported that pension fund Rabobank Pensioenfonds had decided on an initial allocation of €500m. Also that month, Media Pensioen Dienst (MPD), which manages the €4bn PNO Media pension fund, said it had explored risk parity.
Since equities are said to account for more than 90% of the risk in a traditional 60/40 asset allocation, risk parity investors typically lever the lower-volatility parts of their portfolios twice or more to spread the risk contribution from each asset class more equally.
But concerns are spreading that the markets might be due for an increase in bond yields, or perhaps even a 1994-like scenario of a sharp rise in interest rates leading to a more general sell-off of financial assets, and that risk-parity portfolios could face significant problems. In October, JPMorgan Asset Management said in a presentation that investors had to ask themselves whether risk parity had “found the Holy Grail of asset allocation or has just levered bonds during a long-lasting fixed income rally that may soon end”. And indeed it looks like they are asking that question: in January, another Aquila Capital survey of 255 institutional investors found 60% raising questions about the possible effects of interest rate rises on risk-parity portfolios.
“Risk parity seems to assume volatility and risk are the same and we think volatility and risk are very different,” says Matt Kadnar, a member of the asset allocation team at US investment manager GMO. “For us, risk is the permanent impairment of capital – losing money and without hope of making that money back.”
Damage from a 1994 scenario could be large-scale. “In 1994, the US Treasury bond was down -3.4% and the typical bond mutual fund over whole course of the year probably lost 4%,” recalls Edward Qian, chief investment officer and head of research in multi asset at PanAgora. “That’s a pretty big deal for bond investors.”
But most doubt the likelihood of a repeat of the specific circumstances of 1994, pointing out that the damage was done by the Federal Reserve raising rates with no warning or proper explanation.
“There was no anticipation it was going to happen,” says Ed Peters, co-head of global macro strategies at First Quadrant, which just won a risk parity mandate from SAUL (The Superannuation Arrangements of the University of London). “The bond market and stock market both sold off in anticipation that this was the beginning of long series of rate hikes. It turned out the Fed wanted to get to neutral and intended to have one hike but it took the market a year to believe that was the case.”
Today, widespread macroeconomic issues mean that many market practitioners expect interest rates to remain stagnant or fall further in the medium term, and the Fed is signalling its intentions pretty clearly for many months ahead.
If yields do rise, they are unlikely to rise quickly, precisely because central banks will hint at hikes rather than surprise the market as they did in 1994.
“We think interest rates are likely to rise gradually,” says Bob Prince, co-chief investment officer of risk-parity pioneer, Bridgewater Associates. “Markets are always discounting some future outcome. Now markets are already discounting that interest rates will rise. For bonds to be a bad deal. yields would have to rise higher than what is already discounted in. In the next five years, markets are already discounting that interest rates will rise up to 3%.”
Second, risk parity works on the basis that other parts of the portfolio – such as commodities or equities – will perform better while another part stuffers.
“If you have a strong economic environment, that might be the thing to make interest rates rise faster than what is discounted,” says Prince. “Equities would benefit. You need to hold enough equities so that if you have a strong economy you’re holding something that benefits from the strong economy. Likewise, if rising inflation causes higher interest rates, you need to hold assets that benefit from that environment.”
PanAgora’s Qian makes a similar point. “To focus only on the risk of rising bond yields is to neglect the risk of a falling equity market,” he says. “Investors should not forget the possibility that equity markets could fall in the coming year.”
And Peters at First Quadrant reckons that even if bonds go down and stocks and commodities do nothing, its risk parity portfolios will go down 1.3 times an intermediate government bond portfolio – not three times.
“It’s just a slightly longer-duration government bond portfolio,” he points out. “Usually equities and commodities rise when government bonds decline. That largely offsets the decline in bonds and tends to give you a positive total return. The expectation is that we won’t be tanking if bonds go down. We believe the risks are a little overstated to people.”
Furthermore, if risk parity strategies are dynamic in their allocations to risk, they should adapt to any change in risk environment. Michael Mendelson, a principal at AQR Capital Management, points out that when stock-market risk doubles, AQR cuts the amount of stock it owns, and the same goes for bonds. “In 1994, bond risk went up quite a bit – 60%,” he says. “If the same events were to happen today, our position would drop quite a bit, probably as much as 40% to take the same risk level.”
Still, if risk parity managers face problems across asset classes and suffer losses, they should cut their risk targets, says Mendelson. “If your investors’ desire for risk goes down you should also be taking less risk. You don’t want to end up in a situation where investors and counterparties want you to take less risk and you’re not. That gap between those two things can grow too large. It’s not viable.”
Overall, managers seem confident that their risk-parity strategies would ride out an uptick in interest rates relatively well. Bridgewater predicted in its January research that if rates rose due to monetary tightening, a risk-parity portfolio would perform poorly for a short while – about as badly as an unbalanced portfolio held at the same risk level – before performing better than normal once the markets stabilise.
Rather than emphasising the risk of bonds, investors should worry more about equities, according to Mendelson. “What should we really hope for? A very good stock market because all of our investors have an awful lot of stock-market risk. If we ended up underperforming a traditional portfolio because the stock market was very good we’d still be pretty happy. We don’t want a bad bond market and a bad stock market. Investors are still underweight bond risk and overweight stock risk.”