Risk Parity, on Top for How Long?

(April 2, 2012)  —  Funds applying a ‘risk parity’ approach outperformed the rest of the asset allocation peer group over the last three years year, Standard & Poor’s Capital IQ has revealed, while raising concerns over long term performance.

The fund ratings group said across the spectrum of hundreds of asset allocation funds, risk parity-based funds produced double digit returns over the past three years when other strategies struggled to stay in positive territory.  

The report from S&P Captial IQ said the multi-asset funds with a risk parity approach performed the best due to their starting point to hold more in low-volatility assets such as government bonds, typically leveraging them to magnify returns.

The risk parity strategy sees fund managers use leverage to balance out volatility across the total portfolio.

Randal Goldsmith, Fund Analyst and Sector Head in Asset Allocation at S&P IQ Capital, told aiCIO: “These funds have been incredibly successful over the past three years – they made a positive return in 2011 when almost nothing else did – but it will be interesting to see how the strategy performs in the future.”

Goldsmith said leveraging the low volatility aspect of the fund, in this case was government bonds –an asset class that has done very well – had been key to their success, but he wondered if this success would be sustainable.

“These funds performed way above everything else, mainly due to these government bonds that most other managers rejected in favour of corporate-issued debt but what will happen when this asset class does less well?” he said.

To demonstrate the use of leverage in the funds, Goldsmith showed how the AC Risk Parity Fund 7 and 12 performed differently, despite both using the same underlying portfolio. AC Risk Parity Fund 7 produced 6.5% in 2010 and 4.6% to the end of September, whereas the AC Risk Parity Fund 12, which employs a higher level of leverage, made 13% and 4.6% respectively.

Goldsmith said: “There is only a very short track-record for these funds, and although they have performed very well over the last three years they have a very fixed process, which could turn out to be a hostage to fortune.”

The investment industry in the United States, and to an increasing rate in Europe, is divided over the risk parity approach.