(March 22, 2013) — A range of factors inherent in a risk parity approach have unsettled some UBS strategists who have warned investors that the outstanding performance they saw in the last booming decade may be unsustainable.
There are three main issues with the approach, UBS strategists Stephane Deo and Ramin Nakisa found in their research.
Firstly, they worried that investors did not realise that managing risk does not automatically mean managing return.
“In order for risk parity to ‘work’ the implicit assumption is that keeping a portfolio’s risk under tight control will generate good risk-adjusted returns. However, logically this need not be the case,” their paper noted. “Volatility has no sign, and so it is blind to market direction. A strategy that looks exclusively at risk will happily lever up an asset with low volatility whether that asset is drifting upwards or downwards in price over the long term.”
Secondly, the pair said that recent outperformance by the strategy was misleading and by lengthening the time period over which it was measured, a clearer, less impressive picture appeared.
“By extending our analysis to cover the period from 1970-1980 when US treasury yields were rising we find some worrying problems with risk parity,” the authors said. “Overall performance is lower during this period, and when yields gapped higher risk parity amplified the draw-down in fixed income, generating losses of over 20% in 1981.”
The authors warned investors that the last decade had been “unusually benign” for treasuries, but in the coming decade as the Federal Reserve exits its quantitative easing program this is likely to cause yields to gap higher to the detriment of levered fixed income portfolios.
Lastly, UBS warned that combining leverage and credit created an unhealthy mix.
“There are many precedents which show that leveraged positions in illiquid assets can cause severe losses when markets sell off (LTCM, leveraged super-senior CDO tranches, and levered convertible bond arbitrage funds). Qualitatively we are concerned that this strategy is repeating the mistakes of the past,” the pair concluded.
Risk parity has been receiving increasing interest in Europe, having found popularity with investors in North America. Earlier this month aiCIO Editor-in-Chief Kip McDaniel wondered whether risk parity had “jumped the shark” and if the time had come for investors to look elsewhere.
For the full UBS paper, click here.
Related content: aiCIO’s Risk Parity Investment Survey 2012