Experts minimizing fears on risk parity

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.

Edward Qian, chief investment officer and head of research, multiasset at PanAgora Asset Management Inc. in Boston, said, “We've been getting questions about rising interest rates ever since we launched our (risk-parity) strategy” in 2006.

Mr. Qian — who coined the phrase “risk parity” — said that now the yield curve is already pricing in the forecasted rise in rates. Bond returns will still be positive even if interest rates rise, so long as those increases don't exceed what is currently priced into the yield curve, he added.

A scenario like 1994 — when rates unexpectedly spiked — would likely prove detrimental to the majority of asset classes. However, Mr. Qian said he does not foresee the 1994 events repeating given current macroeconomic conditions; gross domestic product and inflation rates were much higher during that time compared with the current environment. It is unlikely that rates will rise much higher above what the market already has priced in 2013.

“Not many people are aware that an appropriately applied risk-parity strategy would have actually worked in 1994 because commodities performed well,” Mr. Qian said.

For the 1994 calendar year, the Russell 3000 index fell 2.5% and the Barclays Capital U.S. Aggregate Bond index was down 2.9%, while the Dow Jones-UBS Commodity index was up 16.6%.

Also, in what NEPC's Mr. Levell called the “hidden observation” in the UBS paper, Mr. Nakisa suggests the Fed should not be perceived as the sole source of rapid interest rate rises. A near-default in 1979 when the U.S. Treasury delayed redemption payments because Congress failed to raise the debt ceiling quickly enough led rates to spike by 60 basis points.

Rate watchers, therefore, should not only keep their eyes on what Federal Reserve Chairman Ben S. Bernanke is saying and doing, but also on the ongoing political discourse in Washington and the potential effects that a government shutdown can have on the Treasury market.

In his report, Mr. Nakisa cites numerous examples in which leveraged positions in illiquid assets led to severe losses: Long-Term Capital Management LP, leveraged collateralized debt obligation tranches and levered convertible arbitrage funds.

On a qualitative basis, Mr. Nakisa said he is concerned that risk parity is “based on leveraged exposure to illiquid assets” and warns investors of “unquestioningly drinking the Kool-Aid.”

Mr. Qian agreed, saying, “Leverage and illiquidity do not mix.”

In its risk-parity portfolios, Panagora avoids instruments like high-yield credit and the use of derivatives subject to counterparty risk, investing only in highly liquid instruments, including credit.

The looming question about the Fed's quantitative easing exit strategy doesn't appear to have dampened institutional investors' interest in risk parity.

Pension funds hiring managers for risk-parity allocations since the beginning of 2012 include the $173 million Lincoln (Neb.) Police & Fire Pension Fund, $67.6 billion Ohio Public Employees Retirement System, $2.3 billion San Antonio Fire & Police Pension Fund, $2.2 billion San Joaquin County Employees' Retirement Association, $2.8 billion Superannuation Arrangements of the University of London and $114.4 billion Teacher Retirement System of Texas, according to Pensions & Investments.

Despite the warnings Mr. Nakisa raises in his report, in an interview he said, “I think it is a great strategy” and “it does well on the whole if you're willing to wait for the long term.”

His concerns lie primarily around the potential for large drawdowns — and investors' tendency to withdraw capital after a large loss.

Mr. Qian stressed that risk parity simply addresses investors' need to diversify and maintain a total portfolio view. At its core, he said “the whole concept is about diversification, and that investors can't let any one view of individual assets persuade their investment decisions.” n