Almost every investment strategy has its time in the sun. Such seems to be the case with risk-parity mutual funds, which seek to equally distribute risks among stock, bonds and commodities to smooth out performance. Popularized after the 2008 financial crisis, parity funds fell out of favor during the long bull market.
Yet now could be an excellent time to invest in one. To equalize the volatility in each asset class, rather than building the typical 50/50 or, more common, 60/40 stock bond portfolio, risk-parity funds leverage their bonds because bonds historically have been less volatile than stocks. With the stock market tanking, the added bond exposure really helps. Moreover, the risk of interest rates rising—harmful to bonds—in what may become a coronavirus-induced recession is very low.
Risk-parity fund assets grew from $74 million at the end of 2008 to over $15 billion in June of 2013, right in time for the infamous “taper tantrum” when yields on Treasury bonds spiked, causing losses in parity funds. (Bond prices move inversely with rates/yields.)
“This slowed the progress in the industry,” says Damien Bisserier, co-creator of the RPAR Risk Parity ETF (RPAR).
Yet in 2020, RPAR Risk Parity’s return is flat while the S&P 500 is down 9% and almost every other asset allocation ETF is also negative. With leverage as of the end of March 31—following an extremely volatile month—long-term Treasury bonds accounted for 42.5% of RPAR’s portfolio, Treasury Inflation Protected Securities, or TIPS, 20%, but more volatile stocks are 25% and commodities, including defensive gold, are 32.5%—for a total of 120%. The fund rebalances every quarter based on its long-term volatility analysis for each asset class, allowing some stability in the allocations in normal market environments.
Other risk-parity funds employ a more tactical short-term approach. “AQR is focused on active risk management,” says Yao Hua Ooi, a manager on the AQR Risk Parity II MV (QRMNX) and AQR Risk Parity II HV (QRHNX) funds. “We adjust the portfolio on a continuous basis to take changing market conditions into account.”
AQR Risk Parity II MV targets a 10% annualized volatility and AQR Risk Parity II HV a 15% one. In the current environment, the funds have reduced their equity exposure to keep the portfolio’s overall volatility below those levels.
Unfortunately, that has prevented them from recovering more of the March losses they experienced during a sharp bounce back in stocks this April. Though ahead of its Tactical Allocation fund category peers, AQR Risk Parity II MV is down 8.2% and HV 12.7% this year, behind the 5.0% loss of Vanguard Balanced Index’s (VBIAX), which employs a simpler fixed 60% stocks and 40% bonds allocation strategy.
A tactical approach can dial back the risk on stocks, commodities or bonds, playing defense when times get rough, and it can dial risk up again when volatility’s low. But sudden shifts in the market can cause problems.
“If you’re in a pretty low volatility environment and you’re risking up certain assets, you could get really hit when that volatility regime changes,” says Alex Shahidi, the RPAR ETF’s other co-creator. “So, we’re more focused on just keeping that fixed allocation that’s based on long term [volatility] averages.”
On Dec. 31, 2019, AQR Risk Parity II MV had 69.7% in equity, 177.1% in bonds, and 42.0% in commodities. By March 31, those weightings were 8.4% equity, 91.1% bonds and 7% commodities. Yet the leverage is misleading, says co-manager John Huss: “If you are not willing to use leverage, you end up naturally overexposed to the riskiest assets. Often times that’s equities. You need to take enough risk to get enough return from your allocation.”
Ooi and Huss don’t see the leverage as applying just to fixed income but to the fund’s entire portfolio. When stock volatility goes up as it has recently, it drives up the portfolio’s total volatility above its 10% target, so they don’t just reduce their equity exposure, but reduce the leverage entirely, so there’s less exposure to every asset class.
Tactical risk parity managers like AQR aren’t just reacting to market volatility. They’re trying to predict it as well with proprietary forecasting models, and adjusting their portfolios’ exposures ahead of time.
“A simple moving average [for short-term volatility] is the kind of risk model people are using for simplicity reasons,” says Hakan Kaya, a senior manager at Neuberger Berman responsible for its risk parity portfolios. Neuberger’s forecasting approach is different in that Kaya believes in a reversion to the long-term mean volatility of each asset class, so if risk is higher than the long-term average right now, he will adjust his exposures but not so much as to assume that vol will stay high indefinitely.
The $2.6 billion Invesco Balanced-Risk Allocation (ABRZX) Management does have a short-term tactical overlay, which incorporates factors like valuation and momentum. These tilts have added value in each calendar year since the strategy’s 2009 inception, according to Morningstar. It targets an 8% annual vol, less than AQR’s two funds. So far, it’s beaten 75% of its peers in the World Allocation fund category during 2020’s stock rout. If today’s volatile market trend continues, its outperformance should, too.
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