A perennial feature of financial markets has always been their aptitude for innovation. After every crisis comes an inevitable wave of products promising a break with the old regime and a solution to the timeless tradeoff between risk and return. Battle scarred from double-digit drawdowns, investors consistently rush into these ‘products du jour’ in the hope that perhaps ‘this’ time it really is different.
2008 and its aftershocks were no exception. Although dating back long before the financial crisis, ‘risk parity’, a portfolio construction philosophy in which asset classes contribute equally to overall risk, has attracted increased attention in recent years. Given a history of lower volatility and limited correlation to equities, resulting portfolios tend to include a high exposure to fixed income markets. This is achieved through leveraged positions in bonds and other historically ‘low risk’ assets.
However, we would practice caution. This under-allocation to equities, whose long-term superior returns will be foregone for the benefit of reducing short-term drawdowns, is a clear drawback to the strategy. However, of more pressing concern is the implicit requirement of falling (or at least steady) interest rates, due to the strategy’s leveraged position in fixed income. Between 1984 and 2013, global bond markets experienced a near constant decline in yields, providing an environment favorable to fixed income portfolios. With rates currently at very low levels, and increasing talk of the ‘ending of the bond bubble’, the outlook today is not so clear.
Similarly, real underlying risk is not well represented by volatility and correlation, both of which can be highly variable and depend significantly on the time period analyzed. Quantitative easing has provided a ‘rising tide’ for most asset classes, a situation that could easily reverse once monetary policy returns to ‘normal’, yields are allowed to rise, and the correlation between bonds and equities enters positive territory. The idea that historical correlations can be relied upon to dampen portfolio volatility will thus be tested as markets, driven substantially by central bank action, react to the end of the five-year easing experiment. Rising interest rate environments will bring with them more volatile performance for fixed income assets, something that has not been experienced in recent years and will likely cause strategies including risk parity to struggle.
Perhaps this time is not different and risk parity will suffer the same fate as those products du jour before it, including balanced funds, 130/30 strategies, and VaR models, to name a few, which will show once again that there is no substitute for simple, sensible investing based on fundamentals.