Risk Parity's Year to Forget
Does a rough 2013 foretell future turbulence for risk-parity strategies?
Risk-parity strategies have burst onto the investment scene during the past few years, an institutional approach that's gained traction with the promise of an "all-weather" strategy, a phrase associated with what many consider the first risk-parity fund, Bridgewater All Weather, a hedge fund run by famed manager Ray Dalio. If the returns of risk-parity mutual funds in 2013 were any indication, however, the weather must have been very inclement indeed.
First, a refresher on the theory behind risk-parity funds. Risk-parity managers argue that the traditional 60/40 stock/bond portfolio derives too much of its risk (as much as 90%) from its equity component. Instead, they allocate on an equal-risk-weighted basis to major asset classes that they believe will offer distinctive portfolio characteristics under different economic regimes. The asset classes used and specific implementation of them varies by fund, but typically covers at least global stocks, bonds, and inflation-hedging assets (usually commodities). In most cases, because the risk approach leads to a high nominal allocation to bonds, the managers use leverage to increase the volatility to a desired level and therefore improve the expected return of the portfolio.
It seems likely that 2013 was not an investment climate accounted for in most of risk-parity's back-tested models. Two of the three major asset classes in most risk-parity offerings, bonds and commodities, turned in paltry or negative results. As a result, by most measures, the returns of risk-parity funds last year were dismal. (There is no risk-parity Morningstar Category, so assembling a list of risk-parity funds is a manual, and possibly error-prone, process.) Every fund we identify as a risk-parity offering returned in the low single digits or worse, badly lagging their respective categories as well as potential reference benchmarks. Neutral-rated Invesco Balanced-Risk Allocation (ABRZX), the behemoth of risk-parity mutual funds at $10 billion in assets, gained about 2% last year. AQR, one of the largest institutional risk-parity managers, saw its retail fund AQR Risk Parity (AQRNX) just break even, with 0.12% for the institutional shares. Managers AMG, Salient, and Columbia all saw their risk-parity offerings lose money in 2013. Bridgewater was no exception to the misery. The Bridgewater All Weather 12% Fund, which reports to Morningstar's hedge fund database, lost 4.6% last year.
It certainly wouldn't be fair to compare risk-parity funds' 2013 returns head to head with the 32% return of the S&P 500 Index, given that only about a third of the strategy's risk budget is allocated to stocks. The sponsors of risk-parity funds often describe them as replacements for traditional 60/40 balanced funds; but risk-parity funds paled by that comparison as well. A portfolio consisting of 60% in the MSCI World Index and 40% in the Barclays Aggregate Bond Index would have returned 14.8% last year. The average world-allocation and tactical-allocation fund--the two categories into which risk-parity funds are placed--returned 10.0% and 8.6%, respectively.
What went wrong for risk-parity funds in 2013, and how concerned should investors be going forward? For one thing, a long-expressed concern about risk-parity funds--that their leveraged exposure to bonds is exactly the wrong stance in the face of a potential secular rise in interest rates--reared its head when the bond market slumped at midyear on fears of early tightening by the Fed. While bond exposure remains a longer-term issue, it wasn't the only problem. Indeed, risk-parity strategies are designed on the assumption that not every asset class will be cruising at the same time, and stocks certainly held up their end of the bargain.
Commodities were another story. Many of the models likely assume that rising inflation usually accompanies falling bond prices, a positive for commodities. But that wasn't the case last year. Not only did inflation remain tame, but demand in key markets such as China continued to slacken. In contrast to the merely de minimis returns of the Barclays Aggregate Bond Index last year, commodity indexes generally lost money (the Dow Jones-UBS Commodity Index lost 9.5%, for example), and the active strategies used by certain risk-parity managers in some cases lost even more than the indexes.
How seriously should investors be concerned with risk-parity funds' recent underperformance? Certainly, many investors are already voting with their feet. Invesco Balanced-Risk saw nearly $1 billion exit the doors in the first two months of 2014.
And there are reasons to be cautious. The two biggest question marks around risk-parity funds aren't going away. If bond yields, as expected, begin to climb from their historically low levels, then 100%-plus gross exposure to the asset class seems like a poor strategic bet. Indeed, critics of risk-parity funds have questioned the timing of such a strategy since their initial rollout, and it's reasonable to wonder whether the back-testing on risk-parity funds was biased by bonds' decades-long bull market. Commodities, meanwhile, for all their inflation-hedging traits, are a notably volatile asset class that, as last year highlighted, can play havoc with the most reasoned asset-allocation plans.
The recent rocky weather shouldn't cause investors to simply abandon ship, however, particularly if they invested in a risk-parity fund for the right reasons in the first place. Most likely, a sensible role would be as a small portion of a broader core allocation, a means of diversifying away from some of the portfolio and performance characteristics of a more traditional 60/40 balanced fund. The newness of most risk-parity funds means they haven't had a chance to prove themselves in their most advantageous circumstances. An inflationary environment is a distant memory, if a memory at all, for most investors, but it was not so long ago that sovereign bonds proved their value as a safe haven while stocks crashed. Because risk-parity managers use different targeted levels of risk, resulting in varying levels of leverage, as well firm-specific methods for implementing allocations within the asset classes, it's critical for investors to learn as much as possible about a given risk-parity strategy before choosing a fund.
More broadly speaking, the recent difficulties of risk-parity funds point to the challenges that advisors and investors face integrating outcome-oriented investments (such as many alternative strategies) into traditional, benchmark-oriented portfolios. As much as investors in theory may favor the notion of curbing downside risk and improving diversification, when they see the S&P 500 rocketing skyward they are likely to wonder, "Where's my beta?" Thus, it's incumbent on fund companies and advisors to properly educate investors on the purpose of vehicles like risk-parity funds, and to point investors to a wider array of benchmarks and risk-adjusted metrics (such as Sharpe ratio and beta) than the standard stock-only comparisons.
Josh Charlson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.