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'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).”
