(July 2, 2013) — Last week marked a bad period in risk parity’s history. After almost five years of solid growth, all risk parity strategy managers saw their fund returns drop by mid-single digits in a matter of weeks.
The investment media headlines were immediately dominated by the apparent shock and surprise that such a fall could have happened in these passive, balanced, and diversified funds–Ray Dalio’s Bridgewater in particular came in for a kicking.
With returns reportedly falling by 8% in the year to date, and 6% in the past month, Reuters declared the result as “a black eye” for Dalio, especially given the strong performance over the past five years.
But was the drop really such a surprise? And was it all caused by Ben Bernanke’s May 22 speech, heralding the beginning of the end of monetary easing?
A brief recap
All the managers aiCIO spoke to last week agree the last two months had been tough on risk parity.
“It is fair to assume that all risk parity strategies have suffered in the last couple of months,” says Michael Mendelson, portfolio manager at AQR. “Market perceptions of changing central bank policy have driven real rates higher and that affects all risky assets.
“In the run up to the May 22 Bernanke speech, the market had already started to get the perception that there was some above-expectation economic news in the US, and as a result you saw equities go higher and other assets, such as bonds, go lower.
“Bernanke’s speech changed the tone and effectively made the real rate increase…the perception was the Fed would have gone faster than they ought to, and the economy wasn’t quite strong enough to withstand further rate hikes. That caused some further sell-offs of assets.”
Continued stresses in emerging markets weren’t helping either, and commodities fell 5% over the period.
Bridgewater’s CIO Bob Prince also cites the great divide between the slow-drip feed of investors becoming less risk averse as a trigger for the bull run earlier this year, and consequent fall of assets in the last few weeks.
“The dominant force in the last couple of years has been a contraction in risk premium, which has affected assets,” he begins.
“As the risk aversion gradually faded, money’s moved out of the curve into other assets, meaning credit spreads are down, real estate is doing better, the stock markets are up, and so forth.
“In the last few weeks, as the markets started to recognise the flow of liquidity from central banks may end sooner than they thought, the markets started a tightening of liquidity conditions, pushing the risk premiums and real yields up, and hurting all assets.”
Surprise?
As all asset returns started to drop, so too did risk parity returns. But this was expected, wasn’t it? If all assets are falling, there’s nothing a diversified portfolio can do to find an upside, right?
“When everything moves down, there’s nowhere to hide except cash,” says Aurele Storno, head of multi-asset at Lombard Odier.
“There was an ignorance [about what a sell-off would mean for risk parity funds] because we’ve not really seen this sort of action before, or gone through this sort of shock since the summer of 2011. Back then it wasn’t a deleveraging shock but an equities one, and the bonds went up in value.”
Some of the surprised headlines may also have been inspired by the speed in which the returns for risk parity fell. AQR’s Mendelson says: “It shouldn’t surprise anyone that in that type of environment, risk parity will be down. How quickly it unfolded was pretty rapid though, and I think that’s why you saw a pretty difficult month and a half for risk parity.”
Scott Wolle, CIO for Invesco’s global asset allocation team, thinks that because we’ve seen so few instances where everything falls, we may have become complacent.
“We looked at how many times, since 1969, all global stocks fell by 5%, commodities fell by 5% and bond yields had risen by at least 25bps, together. The answer is twice,” he says.
Story continues…
Some managers had spotted a trend early however, and had put in place measures to mitigate the downside of all assets crashing down together.
Neil Simons, vice president at Northwater Capital, claims he spotted short-term increases in correlation among asset classes each time there has been expectations about central bank activity. These occurrences included September-November 2010 when there was speculation and then implementation of the second round of quantitative easing in the US, and in August-September 2012 with QE3.
“The episodes of correlation have been short-term, but depending on how one builds and manages a risk parity portfolio, the increase can cause problems,” he says.
“Many risk parity portfolio construction approaches only consider volatility risk; we also consider tail risk and drawdown risk.”
Simons says when they reviewed asset class performance as 2013 progressed, the figures showed there weren’t many asset classes that were providing positive returns. By April that number had dropped to only a select few–most were now moving sideways or down in price instead.
Recognising this, and using the drawdown controls they had constructed, helped minimise their losses. Do the figures stack up? Bridgewater has lost 8% year to date. Invesco’s US risk parity product has fallen 4.07% over the same period.
Northwater Capital’s has lost 2.01% so far this year, bettered only by Lombard Odier’s LOF All Roads basic risk parity product, which lost 1.96%, and its unleveraged Institutional Strategies fund, which lost 1.73%. Food for thought.
A new era?
The question on every investor’s lips right now: is this a brand new era for how assets will behave? Most providers were reluctant to call a major shift in the market.
“This all makes me think of what happened in Wimbledon, where Federer lost to the 116th ranked player. I’m not sure I’d conclude from that match that Federer is a worse player than the 116th, I’d still put my money on Federer if they were to meet again at the US open or somewhere,” says Wolle.
“Even the better athletes can have a bad day, and to say it marks the end of Federer’s career is unbelievably immature. In the same way, we’ve had some over-reaction to the Fed comments, and to extrapolate that into a brand new world seems really premature.”
This is a valid point. Risk parity in itself hasn’t suddenly become a bad product, and something even its most vehement critics will agree on is that, as a basic canvas to start thinking about your portfolio, it’s a good one. Where critics and proponents differ is what happens next.
Leverage has often been a stick used to beat risk parity providers, alongside a perceived over-reliance on bonds. What’s changed in recent months is that leverage itself isn’t seen as the problem anymore; it’s the leveraging of inappropriate assets instead.
Stefan Dunatov, CIO of the UK’s Coal pension fund, says investors should think carefully before levering over-valued assets.
“If risk parity means doing this for bonds, then performance isn’t the issue – you just have a bad investment policy. It is not the leverage that it the problem – it is owning the wrong asset,” he explains.
“The issue I have with risk parity is its ignorance of valuations. The lesson of the 2000 bubble is that starting valuation of assets when you buy them matters. Levering overvalued assets just makes a sin a cardinal sin.”
In the same way that we now recognise that equities were over-valued in 2000, gilts were over-valued in 2012, Dunatov argues. So why is it ok to leverage governments in 2012 but not equities in 2000?
Not everyone agrees bonds are poor value however. Sure, they’re not at the same level as they were five years ago, but taken as a whole, in the past three years the returns have only gone one way: Up.
Erik Knutzen, CIO of investment consultants NEPC, makes the case: “People have said gilts are over-valued for the past three years but all they’ve done since 2010 is go up. They’re probably right, but does that mean they have been right all along the three years?”
Others are more bothered about the basic construct of risk parity products. Arun Muralidhar, co-CIO of AlphaEngine Global Investment Solutions, is typical of the detractors of risk parity products who decry their inability to go short on poorly performing assets.
“I don’t have a problem with leverage, that’s not the issue. The fundamental premise on which risk parity is built is flawed,” he says.
“The problem with all of these strategies is they’re static, they don’t have the ability to go short. They make a naïve assumption that you should always have a positive weight to an asset, whereas I would argue you can still have full risk contributions from every asset but where the allocation can be positive or negative.”
Do risk parity funds need to evolve? And are they already taking steps to do so? And do risk parity strategies have to remain passive, or can we afford to allow strategic tweaking?
In part two, aiCIO interrogates risk parity providers about how they are adapting their strategies to ensure investors aren’t caught out in the event of another perfect storm.
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