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.
GAM didn’t create its approach in response to questions about risk parity, notes Anthony Lawler, portfolio manager and head of custom portfolio solutions in the GAM alternative-investment solutions group, which manages the new funds. “This is how we have been constructing hedge fund portfolios and managing risk for over a decade,” Lawler says. The new GAM strategy invests in about 15 Barclays alternative indexes. GAM overlays quantitative and qualitative analysis to assess where to dial risk up or down, depending on market conditions.
The firm’s offering differs from risk parity strategies in several ways. Because it uses indexes, it’s cheaper: The management fee for $100 million-plus accounts is well below 1 percent, plus execution costs, and there’s no performance fee. It also employs less leverage than many risk parity funds, with lower exposure to fixed income.
Then there’s GAM’s take on measuring risk. Most risk parity funds use so-called marginal value at risk (VaR), or a security’s potential loss on any given day. As UBS’ Deo and Nakisa point out, they also “lever up a loss-making asset even when that asset is falling in value.” In normal market conditions, an asset trading below its long-term fair value should bounce back, and investors can make money with little risk by purchasing it on the way down. But when a market is under stress, the drawdowns and losses can be dramatic, so VaR, which focuses on overall historical behavior, is no longer a reliable metric.
GAM focuses on what will happen to securities in a drawdown, Lawler explains. Its strategy aims to mitigate left tail or downside risk, not overall volatility, as risk parity does. “That is substantially different from other funds which follow Modern or even Postmodern Portfolio Theory,” Lawler says.
Interest in the GAM strategy coincides with strong recent performance and some wobbles by well-known risk parity funds. In the year to date through July 31, GAM Star was up about 5.7 percent, versus 4.63 percent for the HFRI Fund Weighted Composite Index of hedge funds. As of the end of August, Westport, Connecticut–based Bridgewater’s All Weather fund had lost 7 percent, but it gained 1 percent in July and August and 8.5 percent annualized over the past three years. The AQR Risk Parity Fund offered by Greenwich, Connecticut–based AQR was down between 5.31 and 5.49 percent through June 30; a 60-40 portfolio would have been up 7.1 percent during that time. Less than one third of AQR’s assets are in risk-parity-related strategies, and the firm’s overall performance has been positive this year. • •
Read more: How Investors Can Achieve True Diversification — and Better Returns
