Consultants and money managers are playing down concerns in a recent report about the potential affects that rising interest rates and the combination of leverage and illiquid investments might have on risk-parity portfolios.
The report by UBS AG, “When risk parity goes wrong,” aims to show how risk-parity strategies would perform in a rising rate environment and the possibility of a substantial drawdown associated with rising rates. It also cautions investors about the “toxic combination” of leverage and illiquid assets — in this case, credit exposure in a risk-parity portfolio.
UBS constructed a hypothetical risk-parity portfolio made up of U.S. equities, Treasuries, and investment-grade and high-yield debt. It was adjusted so each asset class contributed equal volatility over the trailing three months, targeting a portfolio volatility of 6%.
The portfolio was then back-tested over three periods: a rising rate environment (1973-1981), a falling rate environment (1981-present) and the entire period (1973-present).
The results showed a risk-parity portfolio constructed in such a manner performed exceptionally well over the past decade as U.S. Treasury rates continued to fall.
During periods of rising rates, risk parity “amplified the drawdown in fixed income.” Losses in 1981, for example, exceeded 20%. When the Fed begins to exit its quantitative easing purchase program, Ramin Nakisa, London-based senior strategist at UBS and the report's author, warns that yield increases could cause similar damage to leveraged fixed-income portfolios.
However, Christopher Levell, partner at investment consultant NEPC LLC in Cambridge, Mass., said the typical allocation to a risk-parity portfolio is about 15%, so even in the event of a major unexpected rate increase, the impact of a drawdown on the overall portfolio is likely to be muted.
Studies like the one from UBS are not new. A similar analysis performed by NEPC in 2012 back-tested a risk-parity portfolio over two 12-month periods when the fed funds rate increased: July 1, 1980 to June 30, 1981 and calendar year 1994.
The composition of NEPC's portfolio, however, was more robust — consisting of stocks, bonds, commodities and other inflation-linked assets.
NEPC found that risk parity did, in fact, trail a traditional 60% equities/40% bonds portfolio over the two periods tested. But the underperformance was short-lived — and annualized returns for the risk-parity portfolio in the three years following each period exceeded or kept pace with the traditional portfolio. Risk parity, NEPC argued in that paper, is better positioned to outperform as markets adjust after a period of rising rates.