The October 30 Federal Open Market Committee meeting fueled continuing speculation that the Federal Reserve would soon begin tapering its asset purchase program. The timing of the tapering remains uncertain, but when it does occur, longer-term interest rates are likely to rise. This knowledge has refocused investors attention on risk parity strategies, which contrary to popular belief have historically performed well during rising interest rate environments.
We believe risk parity strategies can be effective tools for protecting investors during rising-rate regimes, but misperceptions about the strategys fixed-rate bond exposures have caused many investors to shy away. The truth is that even if the Fed decelerates purchases and interest rates begin to rise, a risk parity strategy may potentially provide the best asset allocation option for investors.
Whereas traditional asset allocation approaches are not designed to adapt to changing levels of volatility or correlation across and within asset classes, plans for risk parity generally reduce exposure to asset classes exhibiting higher levels of volatility or correlations with respect to other asset classes. This means that if interest rates do increase and stocks and bonds become more volatile or more correlated with each other as they did in the 1970s the exposure to bonds will be reduced in order to maintain a constant level of volatility. If, on the other hand, interest rates rise but the volatility and correlation between stocks and bonds remain constant, exposure levels will remain more stable. In those environments, the bond allocation provides one of the few mitigants to the dual threats of a lower-growth environment and price deflation.
Nevertheless, myths about risk parity strategies persist in the marketplace. The following are the most common misperceptions about approaches to risk parity.
The first such falsehood: Risk parity strategies may be in vogue, but havent they merely benefited from a 25-year period of declining interest rates?
Risk parity strategies are designed to do well in periods of both rising and falling interest rates. Furthermore, portfolios utilizing risk parity do not always contain levered bonds. A risk parity portfolios asset allocation is dictated only by the volatility of each asset class and how it correlates to every other asset class.
Risk parity strategies tended to allocate portfolio assets toward bonds during the past 25 years because during that time frame bonds generally exhibited low correlations to both equities and commodities, as well as lower levels of volatility when compared with those asset classes. On the other hand, during the 1970s risk parity strategies allocated a greater portion of portfolio assets to commodities as a result of the lower correlations that commodities had with respect to both bonds and equities. In a very real sense, commodities offered the principal source of diversification to investors portfolios during the 1970s. Risk parity portfolios do not have an automatic bias in favor of bonds. Equities and commodities can receive higher weights than bonds, depending on the levels of volatility and correlations of those building blocks.
Many of the worst environments historically for bonds proved to be a boon for commodities and other inflation-sensitive assets. For example, between January 1971 and December 1981, when U.S. interest rates reached their peak, bonds would have occupied a less prominent position within most risk parity portfolios. Stocks and bonds were positively correlated for almost every rolling 36-month period during that decade, while commodities were negatively correlated with both stocks and bonds. As a result, many risk parity strategies increased allocations to commodities and decreased allocations to bonds, according to our research, and the average risk paritybased set of investments still managed to outperform the typical 60-40 portfolio.
The second old wives tale about risk parity strategies: The allocations are based on incorrect assumptions about long-term relationships between stocks, bonds and commodities.
One of the key features of risk parity strategies is their adaptability. The vast majority of them are designed to take into consideration how a portfolios different components evolve over time, but they respond to immediate as well as long-term changes. Volatility and correlations between asset classes shift frequently, and we believe risk parity strategies serve investors better than traditional asset allocation approaches because these strategies can adapt swiftly to new realities, whereas traditional allocations respond to none of the information we have about the risk environment.
The third common myth: Risk parity does not embed sufficient levels of human judgment to properly determine asset allocation.
We think focusing on risk is the best tool for creating a truly diversified portfolio and is the essence of the risk parity model. Unlike traditional asset allocation models, risk parity strategies are flexible and designed to anticipate changes in risk because of unexpected market events and trends.
Furthermore, risk parity strategies themselves continue to evolve with the times. Some portfolio managers have incorporated momentum into risk parity investing. Adding a momentum component to a risk parity portfolio can allow investors to tilt toward favorable asset classes and away from those that are out of favor. In addition, momentum sleeves may deliver potentially steady returns to investors during extended drawdowns in equities, bonds or commodities. Combining momentum and risk parity as opposed to allocating to those two structures independently has the virtue of targeting risk at a portfolio level. So, unlike the result of a combined risk parity and managed futures approach, a momentum strategy embedded in a risk parity structure typically constrains the level of risk that can be absorbed as a portfolio becomes more concentrated in any particular component. For example, if momentum strategies favor additional exposures to equity-like investments, the total portfolio exposure would have to be reduced to maintain a constant level of expected volatility.
Investors are understandably nervous about a potential rise in interest rates. Regardless of the Feds actions, we believe the adaptability of risk parity approaches allows investors to achieve truly diversified portfolios that can weather almost any storm.
Lee Partridge is chief investment officer and managing director of Salient Partners, a Houston-based investment firm with more than $18 billion in assets under management or advisement. He was named Small Public Fund Manager of the Year in Institutional Investors 2012 Investment Management Awards.