Opinion and Investing Column

Skarbeck: Weak results take glow off 'risk parity' strategy

July 13, 2013

Ken Skarbeck InvestingThe popular institutional investment strategy called “risk parity” has produced dreadful investment results this year.

The big quantitative investment firms, including AQR and Bridgewater, that manage billions in risk-parity strategies have lost on average 6.75 percent this year, according to Morningstar. In contrast, a 60-percent S&P index and 40-percent Barclays bond index has gained 7 percent.

Risk parity has been promoted as a solution for pension funds to achieve steadier returns in volatile markets. As described in The Wall Street Journal, “The basic idea of the strategy is that by equally distributing risks among stocks, bonds and commodities, the portfolio can weather huge price swings without sacrificing returns.” In its simplest form, this is achieved by leveraging the allocation to bonds and reducing equity exposure.

We wrote about risk parity back in November expressing our concerns. At the time, we thought the idea of leveraging fixed-income securities at historically high valuations was unwise, simply because, when interest rates rise, bonds lose value.

The losses now hitting risk-parity portfolios have occurred as interest rates have risen. The interest rate on the 10-year U.S Treasury bond has shot up from a low of 1.6 percent at the end of April to 2.65 percent today.

Our biggest complaint with risk parity is that there seems to be scant attention given to valuation. We would argue that, at present, bonds are overvalued and can even be considered riskier than stocks. The 30-year bull market in bonds has left interest rates at historic lows. And because it appears that interest rates are poised to eventually rise even further, the strategy may incur further losses.

The key point of debate comes down to one’s definition of risk. Risk parity is focused on volatility as the source of portfolio risk. We disagree, particularly for pension funds that have very-long-term investment horizons. For long-term investors, volatility is not harmful if they have the proper temperament. And, in fact, the ups and downs inherent in securities markets provide opportunities to prepared investors.

Satirically, a statement in a Bridgewater brochure on risk parity actually makes our case: “Every asset is susceptible to poor performance that can last for a decade or more, caused by a sustained shift in the economic environment.”

In our opinion, this is the environment facing the fixed-income markets today—but you have to be looking forward, not backward. And that’s where academic models and their data mining can break down.

The recent losses in risk parity now have the “quants” tweaking their models, adding derivative hedges to protect against further losses. Their academic peers are crying foul, arguing this is a change to the model, which is anathema among the black box crowd.

So is risk parity another example of Wall Street’s periodic investment model du jour? Will it wind up in the dust bin of other concocted strategies that never quite lived up to their promoters’ accolades (such as portable alpha, 130/30 funds, market-neutral strategies and hedge fund-of-funds)? What continues to confound is that intelligent investing doesn’t need to be so complex.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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