With the second round of Quantitative Easing (QE2) now public knowledge, investors worldwide are wondering what effects this policy will have on their portfolio. Even more than the average investor, however, institutional funds – and pension funds in particular – have moved heavily into fixed-income investments in recent years, either through risk parity or liability-driven investment strategies. Understandably, they are wondering how the Federal Reserve’s announcement that it will purchase $600 billion in US Treasuries will affect their investments.
To help these investors, aiCIO has reached out to the vendors offering such strategies, and asked them to comment on the future of their industry. Everything must be taken with a grain of salt, of course – they are, as they would admit, selling something – but such firms wouldn’t be in business long if they lost their client’s money. So here it is: what the men of Bridgewater Associates and PanAgora Asset Management think of QE2 and its effects on bond-heavy portfolio.
QE2 in the short-term…
Bob Prince, co-CIO, Bridgewater Associates: “Given that risk parity portfolios hold a balanced allocation across asset classes, they derive their returns from the aggregate risk premium across asset classes rather than the pricing of any one asset class. The aggregate risk premium of risky assets vs. cash is now relatively high and QE2 is likely to bring it down. This would be good for the returns of risk parity portfolios in the near term.”
Eddie Qian, CIO, PanAgora: “Almost all asset classes have risen in value in the anticipation of QE2. If you look across all asset class, it’s a liquidity injection. So risk parity has performed quite well in the last two months. In the short term, I think it could still be positive.”
Bryan Belton, Director of Macro-Strategies, PanAgora: “One of the things I’ve learned: don’t fight the Fed. They have been very explicit about what they want to do. QE2, the buying of $600 billion in Treasuries, they clearly want to move yields lower. In general, it is not a good idea to bet against them. Last week, watching the non-farm payroll figures come out – exceptional number – [I saw] ten-years yields spiked, and then it fell lower and lower and lower. If there was a reason for them to spike, it was that, but people don’t want to fight the Fed.”
QE2 in the long-term…
Bob Prince of Bridgewater Associates: “Longer term, these influences come and go, leaving a moderate amount of volatility around the longer term expected return of the risk parity portfolio, ultimately leading to an expected return to risk ratio of about 0.6.”
Bryan Belton of PanAgora: “Over a longer-term view, QE2 works or it doesn’t work. What they’re trying to do, they’re very explicit, is prevent Japan. They believe that deflation is a greater risk than inflation. If it doesn’t work, by definition we find ourselves in a Japan-like scenario. We believe that if QE2 doesn’t work, we will see QE3, QE4, QE5 – the limit is not QE2. The point is, if it doesn’t work, look at a risk parity portfolio in a Japan scenario. We have done this analysis and from 1996 to today, compared to a 60/40 portfolio – risk parity performs extremely well. If QE2 does work, the fear is inflation. How do risk parity portfolios perform there? We also looked at 1970s as a case study, and what we found was that risk parity outperformed 60/40 in that environment – spiking interest rates and high inflation isn’t great for equities either.”
QE2 on other asset classes…
Few investors hold only fixed-income investments, of course. The price of other assets will be affected by such liquidity injections, of course, and we asked the same vendors what they thought QE2 would do to the price of other assets held by institutions.
Bob Prince of Bridgewater Associates: “A risk parity portfolio is a balanced portfolio, it is not bond heavy. In our opinion, the aggregate pricing of risk premiums across asset classes is now high. QE2 will distribute another wave of liquidity through financial markets that should contribute to declining risk premiums. On the other hand, the unusual nature of the economic environment, reflected in the need for quantitative easing, is an important reason that risk premiums are high and are likely to remain high over time.”
Bryan Belton of PanAgora: “A meaningful allocation to real assets (TIPS and commodities) is critical for promoting long term wealth creation in an inflationary environment.”
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