Cliff Asness Defends Risk Parity | Chief Investment Officer

Don’t give up on risk parity just yet, argued Cliff Asness in his latest blog post.

The AQR founder defended the recently maligned strategy, explaining away recent performance as part of normal market movements.

“This has been a long and painful relative period for risk parity,” Asness wrote. “But it has not been one that’s historically unprecedented or even unusual.”

Risk parity is designed to offer an edge over “a more traditional equity-dominated allocation,” Asness said, through superior diversification. But, he argued, “better diversification and a modestly higher Sharpe ratio does not always win.”

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Therefore, Asness wrote that it is important to keep a long-term perspective when examining performance. In absolute terms, Asness found that risk parity strategies have grown steadily since 1947, despite drawdowns along the way, with cumulative excess returns reaching 500% by 2015.

“Drawdowns in real life always seem to feel longer and induce more pain than you’d imagine looking back,” Asness wrote. “This is true for risk parity and all of investing.”

Risk parity’s relative performance compared with a 60/40 allocation was less stellar, but still positive, due to “better diversification, in particular making assets like bonds and commodities count as much, but not more than, equities,” Asness wrote.

Recent losses, meanwhile, were caused by a strong equity bull market, a sharp downturn in commodities, and the superiority of US stock market performance over the global equity portfolio implemented by risk parity approaches.

“While recent times have been difficult versus history and versus the zero line, they are well within the bounds of historical experience,” Asness wrote. “While we certainly wish recent times were better for strategic risk parity, we don’t see any evidence that would change our long-term view.”

While it may be challenging to hold onto what seems to be a losing strategy, Asness argued that investors need a better reason to deviate than the realization of “painful results that we, unfortunately, expect to see from time to time.”

“Deciding what is reasonable, allocating to it, then sticking with it… is one of the hardest but most important parts of our jobs,” Asness concluded.

asness risk parity Source: AQR’s “Putting Parity Into Perspective”

Institutional investors are hopeful about the stock market but fearful of volatility in 2016, according to a report by Natixis Global Asset Management.

Of the survey’s respondents, 77% said they expect equities to be the top-performing asset class next year. In particular, 42% of respondents favored global equities, while 33% preferred US equities. The S&P 500 gained 1.6% in 2015 to December 8, according to data provider FE Analytics, despite a turbulent summer.

“We’re seeing a surge in demand for innovative strategies that target specific needs across more diversified, complex portfolios.”Emerging market stocks were also well liked, cited as a potential top performer by 25% of investors. The MSCI Emerging Markets index lost 15% in dollar terms so far in 2015, according to FE Analytics.

However, investors said they were concerned about market volatility in 2016, labeling it the biggest risk to investment performance. In particular, respondents were worried about the effects on markets of political turmoil, economic problems in China, diverging international monetary policies, and changing interest rates.

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Additionally, 84% of investors said they were concerned about the low-yield environment.

“Central bank policies, market volatility, and other outside events have a big influence on institutional investors,” said John Hailer, Natixis CEO.

As a result, investors said their primary goals for 2016 were balancing risk and return and managing volatility in investment returns.

Currently, the average institution dedicates 42% of its portfolio to stocks, with 28% allocated to bonds and 25% in alternatives. Over the next year, investors said they plan to add non-correlated assets and private investments to diversify their portfolios and improve alpha.

“We’re seeing a surge in demand for innovative strategies that target specific needs across more diversified, complex portfolios,” Hailer said.

Another broad asset class that will perform well in 2016, according to the survey, is alternative investments, favored by 63% of respondents. A majority of investors said they believed alternative assets will perform better in 2016 than they have this year.

Half of the respondents said they will increase private equity holdings, while 48% said they plan to increase their stock allocation. Additionally, 46% said they will increase private debt, and 41% said they will invest more in hedge funds.

Meanwhile, 42% investors said they expect to cut their bond allocations—as bonds, along with commodities and fixed income, were selected as the worst performing asset classes for 2016.

Investors also said they intend to make portfolio adjustments when interest rates rise, with 65% planning to ditch longer-duration bonds for those with shorter durations. Other strategies for coping with interest rate changes were reduced overall bond exposures, increased use of alternative strategies, adoption of more absolute return strategies, and geographic diversification.