Hit by a ‘Perfect Storm,’ Risk Parity Managers Try a More Active Approach
Poor performance is expected in a downturn — but these managers say they can stem the losses.
It’s positioned as an all-weather strategy — but risk parity has struggled to hold onto performance amid this latest market storm.
The allocation strategy, which aims to balance risk exposures to different asset classes, has underperformed in 2022 — like most other investments. But risk parity hasn’t blown up like some critics expected.
“Risk parity has been hit by a perfect storm,” said Russell Korgaonkar, chief investment officer at Man AHL. “You have had an environment in which fixed income has been very difficult. You’ve gotten to the end of historically loose monetary policy. That part of the cycle is difficult for stocks as well.”
In some ways, this poor performance should be expected, according to Damien Bisserier, co-chief investment officer at Evoke Advisors, which runs the RPAR Risk Parity ETF. “It’s not a surprise that risk parity has underperformed in this environment,” he said. “You should expect that. That’s the risk you face in a risk parity strategy.”
But risk parity strategies don’t have to be beholden to the whims of the market. Some risk parity managers avoid some of the downside by adding tilts or risk controls to their portfolios — a more active approach to a typically passive strategy.
“Risk parity is a nice kind of framework for thinking about creating a diversified portfolio, but we felt it suffered from a slight issue in the tails,” Korgaonkar said. With this in mind, Man AHL created a more active version of risk parity, which has helped shore up returns during this period of downturn.
Man AHL looks at three types of risk: Short- versus long-term volatility levels, the direction of the trends in the market, and co-movements between bonds and equities. The co-movement risk has been “quite active” this year, Korgaonkar said.
“If a market goes into one of those strong downtrends, we cut the exposure,” he added. “If you think of the volatility shock risk control, that can happen quite quickly. The trend one takes a few weeks to kick in.”
Korgaonkar also highlighted the importance of having a geographically diversified risk parity portfolio. Although it was easy to avoid exposure to other markets during the era of quantitative easing in the United States, that is no longer the case — and managers should respond in kind, according to Korgaonkar.
Man AHL isn’t the only risk parity manager that’s rethinking how the strategy works. Back in 2020, Newton Investment Management’s team realized that quantitative tightening would eventually come back, and that interest rates would not offset equity exposure. At that time, the firm added three levels of risk management to the strategy, according to Roberto Croce, managing director and senior portfolio manager.
One factor Newton looks at is fragility — periods in which prices swing quickly. In most cases, this hurts risk parity strategies, which offload assets amid underperformance. During the Covid-19 flash crash, some risk parity strategies didn’t return to the markets as quickly as they needed to in order to capture the upside, Croce said. “You cut exposure too late and you put it back on too late,” he explained.
Newton has also added “portfolio insurance” in the form of a tail risk hedge that trades rather than buys options, Croce said. The firm also added drawdown controls in 2022, although Croce lamented that it wasn’t early enough to completely avoid the downside.
At Evoke Advisors, meanwhile, Bisserier and his team have avoided some of these more active approaches to the strategy. “Being overly active with adjusting the position sizes can help in some environments, hurt in others, and it adds complexity to a strategy that is already complex,” Bisserier said.
And while 2022 has been painful, he believes the strategy is poised to improve in 2023.
“The major concern with risk parity in recent years was that rates are so low that people questioned the value of bonds, because how much further could rates fall?” Bisserier said. “You don’t have that concern any more. The major criticism of risk parity is no longer relevant.”