Risk-parity strategies drawing big interest despite bond worries

Strategies constructed to ensure that stocks, bonds and other asset classes contribute similar portions of a portfolio's risk are garnering growing interest from institutional investors, even as concerns persist about levering bonds with historically low yields to achieve that result.

Managers of those “risk-parity” strategies - such as AQR Capital Management LLC, PanAgora Asset Management Inc., Invesco Ltd. and First Quadrant LP — say their ability to deliver year-to-date gains of 4% to 7% in a volatile market — even as a 60% global equity-40% global bond portfolio was falling close to 4% — has helped sustain that interest.

Bridgewater Associates LP's $46 billion All Weather Strategy, which helped pioneer the market segment, is up 13% for the year through Sept. 29, noted Robert Prince, the Westport, Conn.-based firm's co-chief investment officer. Unlike competitors who look to get similar risk contributions from different asset classes, All Weather is balanced to neutralize the portfolio impact of asset price changes driven by shifts in economic conditions, he noted.

For the first three quarters of 2011, leading managers of risk-based investment strategies reported combined net inflows of more than $15 billion for those strategies, with All Weather accounting for $10 billion of that total.

The messy market environment of recent months “helps make the case for a portfolio like this,” noted Max Darnell, chief investment officer of First Quadrant, in Pasadena, Calif. In difficult, volatile times, the kind of protection a risk-parity strategy offers becomes that much more valuable, he noted.

Even so, skeptics who warned last year against leveraging bonds to achieve risk parity with equities — at a time when a 20-year bull market in bonds could be nearing an end — said their arguments remain valid, even if they've proven premature thus far.

While the fall in U.S. Treasury yields to all-time lows has continued to buoy risk-parity strategies, at 2% now, “it's hard for yields to fall much lower,” noted Ben Inker, a partner and head of asset allocation with Boston-based GMO LLC. Their eventual rise could do “pretty bad things to risk-parity portfolios,” he said, adding “why you'd want to lever up a 2% yield bond, I have trouble imagining.”

Despite that potential downside, managers say a growing number of institutional investors this year are studying the possibility of putting money into risk-parity strategies with leveraged bond positions, or moving ahead with allocations.

In a recent interview, executives at AQR said their firm's risk-parity offerings have attracted combined net inflows this year of well over $3.5 billion, roughly doubling AQR's risk-parity assets under management. They declined to name specific clients.

Over the past year or two, risk parity has shed its “oddball” image and become mainstream, said David G. Kabiller, founding principal and head of client strategies with AQR.

Robert Job, head of global business development and client relations with Boston-based PanAgora Asset Management, reported similar trends. Net inflows this year of just less than $700 million to PanAgora's risk-parity strategies have helped its AUM reach $2 billion, he said.

Investors who have brought out strategies within the past few years predict greater institutional inflows for their products as well, as they achieve three- to five-year track records. Scott Walle, Atlanta-based CIO of Invesco Global Asset Allocation, said his firm's $2.6 billion Premia Plus risk-parity strategy, which has attracted strong mutual fund inflows this year, is getting more attention from large institutional clients and investment consultants. The strategy, which was launched Sept. 30, 2008, has an annualized gain of more than 14%.

Risk parity has attracted greater scrutiny this year from market analysts as well as investors. For some it remains unclear whether attractive risk-parity performance gains over the past decade prove the strategy's merits or simply reflect the particular market conditions that prevailed during that period.

Without a thorough explanation of what optimization problem risk parity solves, it's tough to draw any conclusions about the strategy, noted Peter Rappoport, a New York-based managing director and head of the strategy group with J.P. Morgan Asset Management. “Anybody who's leveraged bonds as opposed to equities has done very well in the last 10 years,” but people shouldn't confuse a secular decline in interest rates with the success of risk parity, he said.

Do positive risk-parity returns this year suggest superior risk management, or did those strategies “just happen to have levered the year's best performing strategies and hedged down the worst performing strategies?” asked David Holmgren, investment director with Hartford, Conn.-based Hartford HealthCare.

While the argument for risk-based portfolio allocations is a strong one, the argument for leveraging a “low risk” asset such as bonds — essentially “doubling down on a beta trade” — is less obvious, said Mr. Holmgren, who oversees roughly $2 billion in endowment and pension assets for the non-profit. “Levering up an asset class which could fall a little holds the same potential outcome as holding funds in an asset class that could fall a lot,” he said, adding “the (risk-parity) soup smells delicious but the recipe calls for some ingredients I can't swallow.”

Other market analysts — while conceding there's no theoretical reason to conclude that a risk-parity-based portfolio will produce superior investment returns — are more favorable.

Either a traditional 60%-40% portfolio or alternative portfolios can make sense, depending on one's expectations for returns and correlations among asset classes, said Wai Lee, New York-based chief investment officer of Neuberger Berman Group LLC's quantitative investment division. But Neuberger's team found strong evidence that “risk parity is the best starting point” in an environment where there's considerable uncertainty about those forecasts, Mr. Lee said.

By contrast, a 60%-40% portfolio would only be optimal when investors are extremely bullish about the risk-reward trade-off stocks are offering relative to bonds, he noted.

Neuberger Berman will introduce its first risk-parity offering — Neuberger's Dynamic Beta Navigator strategy — later this year, with seed investments from some clients, Mr. Lee said. He declined to identify the clients.

Risk-parity veterans concede that leveraging bonds when yields are near historic lows remains a point of concern for existing and prospective clients alike.

An executive at a multibillion-dollar corporate defined benefit plan with risk-parity allocations, who declined to be named, said “The jury is still out on (Mr. Inker's) warnings.”

Risk parity relies on a negative correlation between bond prices and stock prices, and things will be tougher if some trigger — such as inflation or a “China buyers strike” — causes bond prices and stock prices to become positively correlated, the pension executive noted.

David Graham, a spokesman for the $11.2 billion Ohio Police & Fire Pension Fund, Columbus, said his fund is moving ahead with a three-year plan adopted in 2010 to put a portfolio-wide risk-parity structure in place, even as historic low bond yields have left staff there reviewing how to move forward.

Last year, OP&F levered its global inflation-protected securities allocation by a factor of two while trimming the system's equity holdings, but delayed adding a leveraged long-duration bond component to its portfolio due to concerns about low rates — which ultimately went even lower. “We remain believers that risk parity will in the long run deliver superior returns to traditional allocations, but are nonetheless discussing how to implement the remaining fixed-income piece,” he said.

Still, several managers and investment consultants insist the current extremely low yield environment doesn't undermine the case for risk parity.

Concerns about leveraging bonds in this environment remain a challenge, but depending on the pace of the rebound in yields, relative to expectations, and how it's spread out over the yield curve, a risk-parity strategy should still be able to do better than a traditional 60%-40% portfolio over the long run, said Erik Knutzen, CIO with Cambridge, Mass.-based investment consultant NEPC LLC.

Some managers note that risk-parity strategies have been able to do well in rising rate environments in the past. AQR's Mr. Kabiller said in 2009, as the U.S. economy began to rebound from the depths of the global financial crisis, the yield on the 10-year Treasury bounced from 2.2% to just less than 4%, and AQR's risk-parity strategy still delivered an 18% gain for the year.

Bridgewater's Mr. Prince, meanwhile, noted that leveraging bonds with seemingly low yields can nonetheless produce significant gains if the cash costs of leveraging those bonds are even lower. Investors allocating money to Japanese government bonds in the mid-1990s, as their yields were falling below 2.5%, would have enjoyed compounded returns of more than 12% a year over that period, he said.

Others called into question the conventional wisdom that risk-parity strategies will underperform the traditional 60%-40% mix in a roaring bull market. First Quadrant's Mr. Darnell noted that his firm's risk-parity strategy was launched in March 2009, just as the market began a strong rebound that lifted equity benchmark indexes by almost 100% before the retreat of the past few months. Since that time, First Quadrant's strategy has posted an annualized gain of 20.2% through Aug. 31, compared with an annualized 13.1% gain for a traditional 60%-40% portfolio, he said. n