Some investment strategies intended to better protect institutions in a highly volatile environment are showing cracks under the pressure of the recent market sell-off.
Risk-parity strategies are among the most notable in having suffered in the past six weeks, partly as many managers hold leveraged bond positions that exaggerated losses when both bonds and equities took a hit. In addition, some risk-parity managers also hedge against inflation using commodities and/or Treasury inflation-protected securities, both of which have also declined.
Other investment approaches that attempt to achieve equity-like returns with less risk, such as low-volatility and diversified growth, also are being scrutinized, albeit for different reasons.
“This bounce of volatility is different,” said Richard Urwin, London-based managing director and head of investments in the fiduciary management team at BlackRock (BLK) Inc. (BLK) “If you look back in the past decade and more, what you see is that typically, during high-volatility periods, equity has usually performed badly and bonds would have done well. In the most recent 'risk off' period, volatility is up in equities and also bond yields are up.”
In the first six months of 2013, risk-parity strategies — including those run by AQR Capital Management LLC, Bridgewater Associates LP, Invesco (IVZ) Ltd., Nuveen Investments, AllianceBernstein (AB) LP (AB) and Salient Partners LP — returned between -1.8% and -10.8%, according to data provided by the managers and Wilshire Associates Inc. In comparison, a benchmark of 60% Standard & Poor's 500 index and 40% Barclays Capital U.S. Aggregate Bond index gained 7.1% during the same period.
Volatility also has risen. Data provided by Wilshire indicated about two-thirds of the risk-parity mutual funds covered by the consultant exhibited higher risk than the S&P 500 over the trailing 12-month period as of June 30.
Some notable diversified-growth strategies — which total about $50.1 billion in AUM globally according to data provider eVestment LLC — also have underperformed since market volatility spiked in May, pushing the CBOE Volatility index above 20 for the first time this year. Low-volatility equity strategies continue to outperform, but concern over valuation is building as investors pile into the area, which accounted for about $56.6 billion in global assets under management, according to eVestment.
Investors are rattled
The troubling short-term figures have rattled investors; however, consultants stressed the general concept behind risk-parity, low-volatility and diversified-growth strategies remains attractive. Many of these strategies have made money with less risk for investors over the past three years, they added.
For example, Bridgewater's $70 billion All Weather strategy returned 10.6% annualized over the past three years while Invesco (IVZ)'s institutional risk-parity composite portfolio added 10.5% annualized during the same period, according to data provided by the firms. Nevertheless, both managers have been re-examining the risk/return assumptions underlying their investments.
Bridgewater recently added interest rate hedges to reduce volatility.
At Invesco, managers “were concerned that as bond prices consistently go up, (it creates) an environment in which volatility appears lower than it actually is,” said Scott Wolle, chief investment officer of the global asset allocation team at Invesco, Atlanta, which has about $25 billion in risk-parity assets under management.
“What we came up with was a way to apply both duration and convexity as risk measures for bonds,” Mr. Wolle said. Invesco's bond allocation was reduced by 25% as a result of the new assumptions.
“It's a much more forward-looking view of bond risk,” he added. “We've done something similar to enhance our approach to commodities … and putting the finishing touches on our work in equities.”
The framework supporting risk parity is sound, said Cleo Chang, managing director and head of investment research for Wilshire Funds Management in Santa Monica, Calif. “Our concern is the leverage portion. The risk exposure — given how low rates have been and that they will eventually go up — could insert more risk than what investors expect in risk parity.”
The U.S. five- to 10-year bond yield curve has risen by about half of a percentage point within the past few weeks, said Philip Page, client manager at Cardano Risk Management BV, London, which provides investment consulting and solvency management services to pension funds. “Interest rate (movements) will have a significant impact on the direction of yield and bond prices, and will feed through to equities,” Mr. Page added. “This is a major issue. … Policymakers are really powerful here, affecting not only bonds but also equities.”
On May 22, Federal Reserve Chairman Ben S. Bernanke hinted at the possibility of tapering quantitative easing if unemployment falls to 7% and the economy continues to show signs of stable growth.
Guillermo Felices, London-based market analyst at Barclays PLC, said some strategies that have benefited from the Fed's aggressive monetary policy might potentially experience heavier losses when the situation reverses.
“Over the last few years, safe-haven bonds have played an important role in portfolios, serving as insurance against falls in equity prices,” Mr. Felices said in a telephone interview.
However, that relationship is fundamentally changing, particularly in the U.S. First, bond yields will likely lose value, returning an estimated -2% in the next few years. Second, “bond markets are preparing for a rise in yields, which depress bond prices,” Mr. Felices said. “Therefore, bonds will be less likely to provide effective protection to the volatility in equities.”
Compared with risk parity, diversified-growth strategies are not constrained by the practice of allocating risk equally across the portfolio. In general, diversified-growth funds haven't experienced as steep a fall as risk-parity strategies during the recent sell-off, several consultants said. However, some diversified growth strategies also have been tweaked as the outlook for bonds deteriorates, they said.
For example, portfolio managers at Standard Life Investments have reduced the duration of its flagship Global Absolute Return Strategies Fund to 1.2 years from 4.5 years in the third quarter of 2012.
“It doesn't look like owning duration is very rewarding at the moment,” said Guy Stern, Edinburgh-based head of multiasset fund management at SLI, which has about £107 billion ($162 billion) in multiasset strategies.
In the second quarter of 2013, however, turmoil across markets still put a drag on performance, with GARS lagging its cash benchmark by about 75 basis points. “Certain asset classes that we had expected to go down behaved exactly as expected,” Mr. Stern said. “The problem was that the assets we had expected to offset (the losses) didn't do as well as we expected, such as relative value equities, certain currency strategies and other safe-haven (securities).”
Low-vol getting pricey
For low-volatility equity strategies, the concern is overvaluation. Low-volatility equity strategies have generally outperformed their higher volatility indexes even as markets rally, precisely when such stocks are expected to lag, suggesting low-volatility stocks might be overbought. For example, the MSCI All Country World Index Minimum Volatility index returned 9.6% while the MSCI ACWI rose by 6.4% as of June 30. Volatility was at 8.4% for the MSCI ACWI Minimum Volatility index compared to 10.8% for the MSCI ACWI during the same period.
“We can't draw too many conclusions from the last six weeks,” said Richard Dell, London-based principal within Mercer's manager research team. However, valuations in low-volatility strategies “are looking potentially quite stretched. … If we're considering the longer term both from risk reduction and performance perspectives, the concern is whether now is the time to buy (low-volatility stocks) on valuation grounds.”
R. Dino Davis, institutional portfolio manager at MFS Investment Management, Boston, said the firm built its low-volatility strategy to address some of the concerns surrounding the asset category.
“We thought, diversification is very important” and broadened the number of available low-volatility stocks that can be invested, said James Fallon, portfolio manager.
In addition, MFS also applied fundamental factors on top of the quantitative signals, and as a result, “the investment merit of the stocks helps to minimize any lag in rising markets,” Mr. Davis said. In addition, in the event that low-volatility stocks are indeed overvalued as a group, applying an investment signal will potentially help dampen any reversal in valuation.
The strategy has outperformed the MSCI ACWI by about five percentage points in the first six months of 2013. However, volatility — as with other low-volatility equity strategies — has also been slightly higher compared to the index. Mr. Fallon added: “We don't think (the higher volatility) will have as much an impact in the long run.”
Data Editor Timothy Pollard contributed to this article.
This article originally appeared in the July 8, 2013 print issue as, "Market sell-off hurts risk parity, similar strategies".