Bridgewater's Prince: Embrace Risk Parity Across Entire Portfolio

If you're going to allocate to risk parity products as an investor, you should consider utilizing a similar portfolio construction philosophy for your entire fund in order to achieve balance, Bridgwater's Bob Prince tells aiCIO.

(August 22, 2012) — Risk parity — the investing strategy that focuses on balancing risks rather than allocating of capital — is a portfolio construction methodology that has as much if not more relevance at a total fund level than it has as an investment product.

This sentiment comes from Bob Prince, the co-chief investment officer of Bridgewater Associates, the world’s largest hedge fund, which he and others argue was the originator of a risk parity strategy through its All-Weather fund. Prince notes that risk parity should be the basis of any strategic allocation. “When you think about what a strategic allocation is, it is your agnostic starting point. Alpha is then produced by tactical deviations around that. Risk parity is the mix of assets an investor would want to hold absent a view of markets.” He continues: “That’s what Bridgewater’s All-Weather approach is all about, a balanced strategic asset allocation that delivers reasonable results over time, no matter what the world throws your way.”

The alternative investment approach is the traditional 60/40 asset allocation, which takes a concentrated position in equities and is exposed to sustained economic weakness, Prince adds.

Prince’s comments also jibe with a newly published paper by Australia-based Round Tower Solutions, which notes that allocations to risk parity products will have minimal impact on the fund’s outcomes unless similar portfolio construction techniques are adopted at a total fund level. Furthermore, Round Tower asserts that false expectations about diversification most often result in increased risk taking through leverage. “It is important to guard against this risk, though some leverage will be required,” the paper continues.

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From a theoretical perspective, the paper outlines a number of issues that investors should consider when deciding to implement a risk parity allocation:

1. Risk premiums.

2. Standardizing the measurement of risk — many participants note the issues associated with applying volatility to non-normal distributions and yet most risk parity methodologies still use volatility to scale risk levels.

3. Non-traditional approaches may be superior because they are still not the norm. Behaviorally, if all investors were to switch to a risk parity methodology, Round Tower notes that it would question whether the strategy could maintain its comparative advantage.

“It is difficult to find an asset consultant who does not like risk parity though the approach does have its skeptics who correctly note that much of the difference in past performance between traditional 60/40 portfolios and risk parity portfolios is driven by the larger allocation to bonds (which have performed strongly over the last 30 years),” the firm concludes.

Despite the growing embrace of the concept of risk parity — particularly following the financial crisis — skeptics have also been vocal. In May, for example, a whitepaper published by Hewitt EnnisKnupp asserted that the benefits of a risk parity strategy for a total portfolio are limited. According to the paper by Michael Sebastian, a partner at the consulting firm, risk parity investors are often putting themselves at a loss for ignoring equities in extreme favor of fixed-income.

Meanwhile, last year, Ben Inker, head of the asset allocation group at Boston-based GMO, told aiCIO: “It was largely inadvertent in the start, being anti-risk parity. I seemed to have the field largely to myself. I’ve never felt the urge to write against other products — and I did not do it to be controversial. We have some very serious concerns with risk parity portfolios…Volatility is not inherently a risk. Only when there is leverage in investments is volatility unquestionably a risk.”

In response to such criticisms, Bridgewater’s Prince says that such criticisms of risk parity are largely critiques of leverage, and have not held up well over time. “The assumptions of the All-Weather approach are very basic: risky assets require a risk premium above cash, and the pricing of asset classes reflects discounted cash flows which are affected by the economic environment. Also, risk parity is not a bond portfolio — a bond portfolio would be another concentrated portfolio with vulnerabilities to inflation and rising interest rates. A risk parity approach neutralizes yourself to any particular asset class or economic environment. You just need enough bonds to create balance.”

Related article: Risk Parity Opinions, Crowdsourced

Central banks may have inadvertently traded their control over inflation for the current low interest rates and eased money supply, according to Scott Minerd of Guggenheim Partners.

(August 22, 2012) – Central banks made deals with the devil when they tried to print and spend their way out of the last recession, according to Scott Minerd, chief investment officer at the asset management firm Guggenheim Partners.

“By abandoning monetary orthodoxy and pursuing large-scale asset purchases, global central banks have increased the risk of inflation and compromised their ability to stamp it out,” Minerd argues in a new paper entitled “The Faustian Bargain” after Goethe’s 19th century drama.

In Minerd’s analogy, Ben Bernanke and other central bank chiefs take the roll of Goethe’s bankrupt emperor, and their actions threaten to have similarly disastrous consequences.

“Unlikely as it seems in a world of zero-bound interest rates, someday, as the economy continues to expand, the demand for credit will increase to the point that interest rates will begin to rise,” Minerd writes. “As interest rates rise, the market value of the Federal Reserve’s assets will fall…This could leave the Federal Reserve without enough liquid assets to sell to protect the purchasing power of the dollar, resulting in a downward spiral in its value.”

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Institutional investors can hedge against a potential fall in the purchasing power of the US dollar by allocating funds into real assets, such as commodities and real estate, according to Minerd. Asset managers should let go of US Treasury bonds—which he suggests are “shifting from representing risk-free return to ‘return-free risk’”—in favor of high-yield debt and European equities.

“Inordinately higher leverage ratios and the extension of central bank portfolio duration means governments now face the potential for central bank solvency crises,” Minerd concludes. “It is too early to predict exactly how this Faustian bargain will play out; but, with each additional paper note that rolls off the printing press or gets conjured up in the ether, the likelihood of a happy ending becomes increasingly evanescent.”

Minerd is not the first high-profile CIO to criticize central banks’ policies of low interest rates and quantitative easing. In July, Pacific Investment Management Company’s Mohamed El-Erian argued that rock-bottom interest rates hurt institutional investors without lifting the global economy. “Lower borrowing costs are not enough to convince companies to expand given the [current] list of domestic, regional and global uncertainties,” he asserted.

Minerd’s entire paper is available here.