A New Way to Balance Risk

Risk parity is one of the new ideas to reach mutual funds. Invesco uses the approach in its Balanced-Risk Allocation (ABRZX) and Balanced-Risk Target Date funds. AQR just launched the AQR Risk Parity fund. Its aim is to balance out risk among a number of factors based on recent volatility in those factors.

Its backers say this is a big improvement on the classic 60/40 balanced fund while critics say that it is needlessly complex. GMO's Ben Inker authored a critique; click here to read a portion of it.

What follows is the transcript of Morningstar's question-and-answer session with AQR founder Cliff Asness, in which he explains and defends risk parity.

Q. How do you achieve risk parity?
Asness: Risk parity is really about building a portfolio that should be more resilient through different economic regimes by investing in a risk-diversified portfolio. Traditional diversification has focused on investing across a large number of different asset classes, but because equities have disproportionate risk, traditional portfolios' risk allocation is typically dominated by their exposure to the equity markets. Risk-parity portfolios instead balance the exposures by risk across many asset classes. To achieve this balance, a risk-parity portfolio will hold smaller exposures in asset classes with high levels of risk (such as equities and commodities), and larger exposures in asset classes with lower levels of risk (such as bonds and TIPS). We believe this offers investors true diversification.�

Q. How does a risk-parity portfolio differ from simply holding a lot of long-term bonds in a balanced portfolio?
A. While holding a lot of long-term bonds would generally help to better diversify a typical balanced portfolio, that's quite different from what we think of as risk parity. For one thing, risk parity is about holding less equities and more of everything else, not just bonds. Also, the way we implement risk parity involves dynamically adjusting the amounts we have invested across asset classes to help maintain a risk-balanced portfolio. For instance if, down the road, bond markets become more volatile, we'll naturally reduce our holdings of fixed income in order to maintain the risk exposure to fixed income. We believe holding a static (or rebalanced to fixed weights) portfolio of anything subjects portfolios to changes in underlying market volatility, often at the worst times.

Q. Does volatility always precede a market sell-off?
A. Nothing happens the same every time, but for the vast majority of historical sell-offs, you do find that market volatility tended to pick up beforehand. Many people feel as though the 1987 crash came out of nowhere, but the market did indeed increase in volatility the few days beforehand. We use fairly short-term forecasts of volatility to stay on top of these potential quick changes in the underlying markets we trade in.

Q. How much easier is it to predict risk or volatility than returns to an asset class? Is there any way to check the relative accuracy of return and volatility/covariance estimates?
A. The analogy we typically use is to ask someone to forecast what the temperature will be like tomorrow. They will likely go with what the temperature is today, and that will usually end up in the right ballpark. If you ask the same person what they think the change in temperature will be from today to tomorrow then they have at best a 50/50 chance of even getting the direction correct. Forecasting volatility is much easier because it's closer to a level than returns, which are more like a change.

One way of checking forecasts of volatility and returns is to go back in time and review how accurate the various forecasters have been at the two. If you go back and look, you'll find that most people will have probably forecasted that equities would have been more volatile than, say, bonds over the last decade, but they likely would have also said equities would have outperformed bonds--which in hindsight wasn't the case.

Big picture, for any manager, timing markets is a difficult thing to do. It's a zero-sum game in the end where losers must pay the winners. We don't think having the bulk of your results rely on the skill of any one manager will ultimately lead to consistent results. Eventually, given the difficulty of timing markets, any manager--no matter how skilled--will have their tough times.

We have a lot more confidence in the results of an investment strategy where the bulk of its returns depend on a well risk-diversified portfolio. As such, we've built our strategy around a strong core, where we try to add some value by making moderate adjustments around that core when we have strong views.

Q. The fund is designed to manage four risks. Are you assuming that there's one asset class to adjust up or down for managing each risk or are they related?
We invest across a portfolio of roughly 70 different exposures across four major "themes." Those break down into equities, nominal fixed income, inflation, and credit. They are certainly all related, and some more so than others. Equities and credit should perform well in a low-inflation, high-growth environment. Fixed-income should perform well in low-inflation or recessionary environments. Commodities and global inflation-linked bonds should perform well during inflationary times.

Q. How do you gain exposure to those asset classes?
A. Most of the exposures (equity, developed nominal bonds, and commodities) are achieved through futures or futures-linked instruments. We buy global inflation-linked bonds directly, and use forwards and swaps to get exposure to the global currency and credit markets. All instruments we trade are quite liquid and easily priced.

Q. With talk of a bond bubble, isn't this a bad time to increase bond exposure?
A. Bubbles form when people are buying securities beyond fundamental value where the only way to gain depends on the hope that someone else will later buy at a higher price. We don't think we are at that point in the global bond markets. There are real fundamental problems with the global economy that have led governments to pursue measures such as quantitative easing. We have heard for a few years now that "yields can only go up from here." The bond market is pricing that consensus view in when you consider that the term structure of interest rates is steep (the market expects yields in the future to be higher than they are now). That means you can make money owning bonds today as long as interest rates don't rise as fast as the market currently expects.

Time will tell, of course, whether bonds are actually at a peak now. The important part of risk parity is that bonds are only a portion of the exposures, and specifically in our implementation nominal bonds only represent one fourth of the risk of the portfolio. If the economy does turn around faster than markets expect, we would anticipate potential gains from our exposures to equities, commodities, and credit and to the portfolio overall. If the world economy remains anemic, we will be grateful for having at least a meaningful portion of our risk in fixed income.

Q. How are all these short-term rebalancing actions every few weeks helpful to investors with a time horizon of years or decades?
A. Investors should have a long-term investment horizon, but in order to maintain diversification of exposures through time, we dynamically adjust position sizes up and down based on our short-term forecasts of market volatility. Specifically, if we see a market becoming more volatile, we'll reduce exposure to that market (and vice-versa). Having a consistent amount of risk (as opposed to capital) exposed to a market has historically given more consistent performance, and has improved distributional properties (less tail risk, for example). We find that this leads to severe drawdowns occurring roughly one third less often, and when they do occur, they are one third less severe as opposed to a passive constant dollar investment in a portfolio. So, we aim to have relatively consistent risk through time and also relatively consistent risk balance across our exposure through time (aside from the moderate tactical adjustments we employ).�

Q. How long have risk-parity portfolios been in use by institutional money managers? Have we seen any forced sales or other impairments from the leverage in that time?
Risk-parity strategies have been pursued on the institutional side since the mid-1990s. Risk-parity strategies hold liquid instruments, and aren't required to actually borrow cash to get the leverage required to diversify the exposures in the fund (futures and swaps are used for this). Because these derivatives only require a small amount of initial margin to maintain the economic exposures, there is typically a very large amount of cash to handle market-to-market movements and flows.

So, even in the depths of the credit crisis, risk-parity strategies did not have difficulty managing their exposures and there was no "forced selling" given how these strategies are managed.

Q. What are the tax implications of this fund given the leverage and turnover? Should it be limited to tax-sheltered accounts?
A. Much of the exposure in the fund is through futures contracts, which are given 60% long-term capital gains, 40% short-term capital gains treatment by the IRS, regardless of how much trading is done in them. Other holdings include inflation-linked bonds and swaps (where the capital gain will depend on how long we hold the security/swap). We'll aim to optimize those exposures to minimize taxes to the end investors.

Q. Will this fund be available in no-transaction-fee supermarkets?
A. Yes, the ticker is AQRNX.

� Diversification does not eliminate the risk of losses.

� Past performance does not guarantee future results

Cliff Asness is a registered representative of ALPS Distributors, Inc.

Principal Risks:

Foreign investing involves special risks such as currency fluctuations and political uncertainty. The use of derivatives, forward and futures contracts, and commodities exposes the Fund to additional risks including increased volatility, lack of liquidity, and possible losses greater than the Fund's initial investment as well as increased transaction costs. This fund enters into a short sale by selling a security it has borrowed. If the market price of a security increases after the Fund borrows the security, the Fund will suffer a potentially unlimited loss when it replaces the borrowed security at the higher price. Short sales also involve transaction and other costs that will reduce potential Fund gains and increase potential Fund losses. When investing in bonds, yield and share price will vary with changes in interest rates and market conditions. Investors should note that if interest rates rise significantly from current levels, bond total returns will decline and may even turn negative in the short term. There is also a chance that some of the fund's holdings may have their credit rating downgraded or may default. Actual or realized volatility can and will differ from the forecasted or target volatility described above.

This Fund is not suitable for all investors. An investor considering the Funds should be able to tolerate potentially wide price fluctuations. The Funds may attempt to increase its income or total return through the use of securities lending, and they may be subject to the possibility of additional loss as a result of this investment technique. The Fund is new and has a limited operating history.

Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. To obtain a prospectus containing this and other important information, please call1-866-290-2688 or visitwww.aqrfunds.comto view or download a prospectus online. Read the prospectuscarefully before you invest. There are risks involved with investing including the possible loss of principal.

Past performance does not guarantee future results.

ALPS Distributors, Inc and AQR Funds do not provide tax advice. Please seek professional tax advice before investing.

AQR Funds are distributed by ALPS Distributors, Inc.

Definitions:

Covariance: A measure of the degree to which returns on two risky assets move in tandem.

Forwards: A cash market transaction in which delivery of the commodity is deferred until after the contract has been made. Although the delivery is made in the future, the price is determined on the initial trade date.

Swaps: The exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed

Tail Risk: Given a normal distribution of returns, a risk that a given return will be a negative outlier reflecting a severe loss.

TIPS: A treasury security that is indexed to inflation in order to protect investors from the negative effects of inflation.

Volatility: A statistical measure of the dispersion of returns for a given security or index.

GMO's Ben Inker authored a critique of risk parity. The full article can found here (registration required). This is a passage refuting some of the claims made by AQR founder Cliff Asness:

"We believe that there are three basic weaknesses in risk parity portfolios. First, these portfolios suffer from the same basic flaw as value-at-risk and other modern portfolio theory tools--they confuse volatility with risk, assuming that if the standard deviation of the portfolio over some particular time period is x%, this is really all the investor needs to know. Second, some of the asset classes generally included in these portfolios have risk premiums that we believe may well be zero or negative for the foreseeable future. And third, several of the asset classes involved in these portfolios have significant negative skew, which makes the backtests behind them suspect and, in conjunction with leverage, may prove extremely painful to investors."

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