Call it the holy grail of investing: a strategy that protects against downside risk and enhances rather than limits returns. Institutional investors have chased that dream since Modern Portfolio Theory took hold in the early 1960s after showing that a mix of assets could cut risk and boost overall results. Given worries about rising interest rates and the chance of another global recession, the quest has taken on even more urgency as institutions seek to insulate their portfolios from disaster.

Since 2008 many of them have turned to a portfolio construction strategy called risk parity. Edward Qian, CIO of Boston-based PanAgora Asset Management, coined the term in a 2005 white paper. Popularized by the likes of $145 billion Bridgewater Associates and $84 billion AQR Capital Management, risk parity is a quantitative and qualitative approach to asset allocation. It builds a diverse portfolio — commodities, currencies, equities and debt — with an emphasis on risk management. The diversity reduces risk to a greater degree than a typical 60-40 equity and bond portfolio while producing better returns.

But as risk parity gains traction, partly thanks to its performance in 2008, critics are asking how well it will do in the next downturn. In March, Swiss investment bank UBS published a report called “When Risk Parity Goes Wrong.” The authors, strategists Stephane Deo and Ramin Nakisa, note that most risk parity strategies have a relatively low allocation to equities and relatively high exposure to leveraged fixed income. Such funds may not measure risk conservatively enough, they suggest.

GAM portfolio manager and head of custom portfolio
solutions Anthony Lawler

Deo and Nakisa question how risk parity will fare if interest rates rise. “There are many precedents which show that leveraged positions in illiquid assets can cause severe losses when markets sell off,” they write, citing the 1998 failure of U.S. credit arbitrage hedge fund Long-Term Capital Management. Risk parity could be the next leveraged investment disaster, Deo and Nakisa warn.

London-based alternative-investment firm GAM thinks it’s developed a strategy with all the advantages of risk parity and fewer potential problems. Early last year $120 billion GAM announced it had partnered with London-based Barclays Capital, the investment banking arm of Barclays, to launch the GAM Star Barclays Dynamic Multi-Index Allocation, which it offers to European investors as an Undertakings for Collective Investment in Transferable Securities (Ucits) fund. The firm also launched an institutional fund in the U.S., where it’s close to receiving a sizable allocation from a public pension fund.