Risk-parity investing, which ballooned in popularity in the aftermath of the financial crisis, may be entering the latest test of its efficacy. According to some investment market practitioners, peculiar market dynamics have raised questions about the performance potential of the strategy, for this year at least.
“Risk parity has enjoyed an unusually good environment for the last 18 years because correlations have been unusually low (see Aon chart on historic correlations below; return correlations between the Barclays Capital U.S. Aggregate Bond Index and the S&P 500 have averaged –0.1 since Jan. 2000 ). But I don’t see why we would expect that to remain the same going forward,” said Chris Walvoord, partner and global head of hedge fund research at Aon. He added that “for some clients, risk parity can make sense depending on what the rest of their portfolio looks like, but tactically we don’t think now is good time to be adding to the strategy.”
“I think that expecting the returns we saw from the strategy in 2016 or 2017 is unrealistic. The reason for that is that there are a number of factors at play that were not at play two years ago,” according to Banjamin Patzik, who heads liquid alternative, hedge fund, and opportunistic research efforts at consulting firm Segal Marco. “So, is risk parity primed to benefit form market conditions today? Not necessarily,” he observed.
What is risk parity?
Risk parity is a multi-asset tactical allocation investment approach designed to balance the risks from various asset classes evenly in a portfolio based on the inherent risk profile of individual asset classes. The strategy’s objective is to deliver a constant stream of risk/adjusted returns over the long term. “So, the manager’s goal is not to knock the ball out of the park in any given year. At the end of the day, the goal is to generate consistently strong risk-adjusted performance and a consistently high Sharp ratio,” Patzik explained. He noted that most risk parity managers will generate a Sharp ratio of between 0.7 and 1. The Sharpe ratio measures an investment’s returns per unit of risk. It is calculated by subtracting the risk free rate (the rate of return of an investment with no risk) from the portfolio’s expected return and dividing that by the portfolio’s standard deviation of return. Generally, the greater the value of the Sharpe ratio the more attractive the risk-adjusted return.
The strategy tries to account for or accommodate economic conditions across and throughout entire economic cycles such that the overall portfolio can withstand declines in any specific asset class at any time without fear of an overall portfolio rout.
“These solutions are meant to serve as diversifiers, first and foremost. When one combines different asset classes into a single fund wrapper, one should expect the portfolio to generate a differentiated return stream relative to traditional asset class allocations,” Patzik explained.
Risk parity balances the risk in a portfolio based on the inherent risk profile of the underlying assets. “The environment into which we are entering is not particularly good for risk parity,” Patzik said. The conditions to which he referred include a rising interest rate environment and a period of potentially heightened inflation. “Inflation and fixed-income don’t really go well together. How that has influenced central banks’ thinking and actions could have implications for risk parity. We are in a weird environment in which global central banks are trying to toe the line in allowing economic growth while tempering economic growth. They are actively raising rates and hoping for inflation to pick up. How that impacts the broader market dynamic is very uncertain,” Patzik said. “The whole point of risk parity is that you don’t want to allow any single asset class to kill you when it performs poorly,” stated Robert Croce, managing director, quantitative strategies, at Salient. “A risk parity investor applies this principal to bonds and everything else in their portfolio. Over time we will make money in every asset class, and we don’t care so much where it will come from this year; that’s unknowable ahead of time.”
Salient boasts $14 billion in total assets under management, $500 million of which is in risk parity strategies. Global risk parity assets currently stand at approximately $250 billion.
The performance of global risk parity strategies has seesawed over the last handful of years. In 2015, for example, a wide swath of asset classes generated negative returns, with U.S. equities representing one of the best performing assets with a 1.4% return; risk parity strategies returned across a range of – 8% to -12% approximately, one consultant said.
“So when risk parity investors asked ‘how can this strategy give me such negative returns?’ the answer was that’s because in 2015 correlations between asset classes was so high,” Patzik said. He added that 2016 represented the opposite situation. “Global equities did well. Commodities—a major component of risk parity investing—rebounded to some degree, and fixed income was as steady as she goes. The slight rise in interest rates was insignificant enough that fixed-income managers could still capitalize in certain sectors. So, overall, risk parity performed well.”
The wide disparity in risk parity strategy returns in 2015 and 2016 was partly the result of overall market performance and partly a function of the assets in which portfolio managers were investing.
“There is really only one downside to the strategy: headline risk,” Croce said. The next time stocks are up 30%, reporters and/or board members will point out that the plan down the road made more money with a less complex portfolio over some arbitrary, short period of time,” he said, adding that investors considering a risk parity allocation (or anything that increases their differentiation from peers) need to have a keen sense of how much shortfall they can withstand politically during periods of underperformance, then allocate accordingly. “We see many of the big public plans moving toward a 10% static allocation to risk parity. That should deliver substantial portfolio benefit and maximum underperformance versus peers of something like 3% in a year when stocks are up 30% and risk parity returns zero, like 2013.”
In the absence of other constraints, he continued, investors should run their entire liquid portfolio in a risk parity framework, he advised. “But there are other constraints; the maverick risk of running a pure risk parity portfolio would be massive. Fortunately, even a 5%-10% allocation can have a big impact on returns and risk. A 10% allocation to risk parity, funded by selling stocks, increased returns by 70bps versus the 60/40 portfolio and reduced risk as well. (See chart.)
How about concerns regarding strategy’s use of leverage?
The correct answer here is “it depends,” Croce said. The most powerful thing about Salient’s strategy is the speed with which it adapts to new risk environments, he claimed. “In very low-risk environments, we will have a little bit more leverage in the portfolio and in very high risk environments leverage will be low or even completely absent. We think this makes sense because low risk environments can be very rewarding, especially on a risk adjusted basis. 2017 is a great example. The S&P was up over 20% and had a realized volatility of well under 10%, yielding a Sharpe ratio well over 2!”
Croce says that this year, through the close of April, his risk parity funds have basically been flat, while bonds were down 5.5% for that period. “Clearly, risk parity isn’t just levered exposure to bonds, or we would be down 11%,” he noted.