‘All weather’ risk parity strategy loses its shine

Opinion

Grant Wilson

Risk parity was a winning asset allocation strategy, until it wasn’t. Now it has passed its sell-by date, but it will not go gently into the night.

Grant WilsonContributor

Last weekend we explained how the era of offshore bank funding was over. There are many other tectonic plates that are shifting in global capital markets at the moment. The asset allocation strategy known as risk parity is one of them.

Risk parity is a simple idea: it involves equalising the contributions to risk from the different asset classes that comprise a portfolio.

Ray Dalio of Bridgewater. The giant hedge fund is a proponent of risk parity investing but has recently tweaked its strategy. Sam Mooy

The typical implementation commences with targeting volatility for the portfolio as a whole, often in the range of 10 to 15 per cent. Allocations to equities, bonds, and other sectors are then derived based on measures of expected return, risk and correlation.

The strategy has been accompanied over recent decades by an aggressive marketing campaign from many of the world’s leading asset managers.

They have positioned risk parity within the classic framework of Modern Portfolio Theory, where investors are assumed to be risk averse.

The basic pitch has been that risk parity can increase returns for a given level of risk, or lower risk for a given level of returns.

In this way, risk parity has been presented as an alternative to the classic 60/40 allocation between equities and bonds.

Our view is that risk parity is beyond being retooled. It is fundamentally broken now.

It typically involves leveraging the bond allocation significantly, a step which is expected to truncate drawdowns at the portfolio level.

Risk parity has been implemented in scale both externally (by asset owners engaging managers for a fee), and internally (by asset owners retooling benchmarks).

And, of course, in our world of financial innovation, there are now risk parity Exchange Traded Funds (ETFs) available.

All weather

Risk parity has become synonymous with an ‘all weather’ portfolio, principally due to the juggernaut that is Bridgewater Associates.

As COVID-19 roiled financial markets in March, we were given a real-time illustration of the shortcomings of this slogan.

Early on, risk parity functioned largely as advertised, with the sharp decline in equity prices counterbalanced by lower bond yields. On March 9, the 10-year US Treasury yield reaching a historic intraday low of 0.32 per cent.

From there things went wrong. The S&P 500 fell a further 13 per cent through March 18, yet bond yields reversed higher, to 1.19 per cent.

This was a worst-case for risk parity, as it involved drawdowns on both sides of the book. In quantitative terms, the negative correlation that was assumed to exist between the price of equities and the price of bonds failed.

This brought risk management protocols into play, both due to the magnitude of the drawdown at the portfolio level, and due to the departure from the targeted volatility.

As risk parity is a levered strategy, margin calls were also a feature.

The Fed then rode to the rescue, tentatively on March 15, and then with unlimited quantitative easing on March 23. These steps restored market functioning and liquidity, and ultimately defined a cycle low in global equity markets.

As we wrote at the time, the Fed effectively bailed out the risk parity sector.

Damning dispersions

The performance realised by risk parity managers through this period varied significantly. On a peak to trough basis, down 20-50 per cent is a useful estimate of the range in mutual fund space.

The dispersion owes to differences in the underlying portfolio construction (these vary widely), and due to differences in risk management protocols, including the execution thereof.

Of course, in the event it would have been preferable to ride through the volatility, as an unlevered 60/40 portfolio might have done.

The storm was too perfect, however, in exposing the risk, return and correlation assumptions in an environment of fractured market liquidity.

The subsequent recovery in performance (which owes principally to the rally in equities and credit) has quelled the most vocal critics of risk parity.

The proponents are again on the front foot, and ETF inflows have resumed.

A notable exception is Bridgewater itself, which is on pubic record in having tweaked its strategy away from government bonds and towards gold- and inflation-linked bonds.

Our view is that risk parity is beyond being retooled. It is fundamentally broken now.

Our starting point is the levered bond component. We agree that with nominal yields so low, the portfolio protection afforded by this allocation is limited.

There is still some positive yield and rolldown, and central banks are expected to ‘control’ yields for the foreseeable future through a combination of asset purchases, forward guidance and by requiring banks to own high quality liquid assets.

But there is not much juice left.

Real yields are also now deeply negative, implying that while capital may be preserved in nominal terms, it will be inflated away in real terms.

Crucially, even if capital losses on the bond allocation are not realised, there has been a structural decline in fixed income volatility, and a renewed breakdown in realised correlation as between equity and debt.

The MOVE Index in the US captures the former well, having hit historic lows in late July.

By contrast, the VIX index (equity volatility) and CVIX (foreign exchange volatility) remain materially higher than before COVID-19.

We think this is more of a feature than a bug. While the Fed has dialled back asset purchases, its commitment to low and stable yields is reflected in its recent endorsement of targeting average inflation.

We have also seen this movie before. Since the advent of yield curve control in Japan in 2016, Japanese government bonds have been moribund.

Even here in Australia, where the RBA has been relatively orthodox, yield volatility at the front end is now so low that the ASX is launching a 5 years future contract.

For risk parity, this presents an existential challenge.

To maintain parity, the leverage ratio deployed on the bond allocation will need to rise, providing more notional exposure to an asset class that has negligible or even negative risk premia.

Alternatively, the equity allocation could be reduced, providing less exposure to an asset class with positive risk premia.

Neither is a good outcome.

Time to exit

The sheer weight of money and influence that underpins risk parity ensures that it will not go gently into the night.

On the contrary, we expect to see more rejigging and rebranding. But even here we would be wary.

Gold is enduring an unprecedented shock to demand that has been masked by rampant ETF inflows since Q2.

And linkers, while providing (two-way) exposure to inflation, are rich and illiquid.

There may be cases made for commodities and foreign exchange as well. However, the risk premium associated with these asset classes is dubious, and the relationship with equity markets is unstable.

There is similarly nothing to see within emerging markets, other than as a substitute to the equity allocation within risk parity.

To be sure, there are other ways to hedge a risky portfolio, by utilising equity and credit derivatives, for example. But here, the resulting portfolio would look more like a hedge fund than risk parity.

In short, whichever way we look at it, we do not like it.

It is time to exit risk parity in full, and return when its basic precepts are restored by the market.

Grant Wilson is head of Asia Pacific at Exante Data, a macro advisory and data analytics firm that provides research to institutional investors, central banks, corporations and private banks.

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