The investment community has shown increasing concern in recent weeks over the sharp rise in interest rates from their current historic lows, triggered either by the removal of the highly accommodative monetary policies adopted by governments worldwide or the inflationary pressures from a continued expansion of the monetary base. In our view, this preoccupation with interest rates stems from the fact that most investors have never encountered a regime of significant and sharp increases in interest rates during their investment lives. Still, this has led to consternation about bond portfolios, but perhaps even more anxiety about risk-parity strategies that may carry leveraged bond positions.
The period between 1971 and 1982, the last stretch of consistent, sustained rises in yields in the U.S., provides the most useful testing ground for investors' concerns. Using a simple risk-parity portfolio constructed with equities, bonds and commodities that is rebalanced to equal risk on a monthly basis, we first consider risk-parity's performance based on the actual trajectory of yields over that period. Since actual yields in 1971 provided an income buffer to bond returns, we also examine risk-parity's results as if the yield on the U.S. 10-Year Treasury bond in 1971 was 1.6%, approximating the 2013 low.
Over the long term, an unlevered risk-parity strategy would have an average allocation of 48% to bonds. Indeed, risk-parity's bond exposure would have been consistently high for much of the 1970s prior to the significant rate increases. This is intuitive even without considering correlations: bonds represent a fundamentally less risky asset than equities and would nearly always require a larger weight to achieve the same level of risk in a portfolio. Thus, the perception among many investors is that history may be repeating itself — that a low-rate environment coupled with significant exposures to bonds in risk-parity strategies will be followed by sharply rising rates and poor returns to those strategies.
Yet when we examine risk parity in the period between January 1971 and December 1981 we find that a simple implementation of risk parity would have (1) generated positive nominal returns and (2) outperformed an allocation strategy with comparable volatility, namely a benchmark of 60% equities and 40% bonds. Risk parity would have experienced a cumulative return of 235%, while the 60/40 portfolio would have experienced a cumulative return of 118%.
Why is this true? Because risk-parity exposures are not static.
The fact that risk-parity exposures are designed to be dynamic is one of the most important differentiators from traditional, static allocation schemes. When asset class returns become more volatile or more correlated with other asset classes, classic risk-parity strategies respond by lowering exposure to the asset classes exhibiting higher volatility or higher correlations with other asset classes. By contrast, traditional, static asset allocation strategies are not designed to adjust to changing levels of volatility or correlation. Consider, for example, that stocks and bonds were positively correlated over nearly every rolling 36-month period in this analysis. This means that bonds would have typically been a less prominent asset within most risk-parity implementations, something we believe is a reasonable assumption in a future period of rising rates.
In contrast, commodities, which were negatively correlated with either stocks or bonds over 97% of rolling 36-month periods between 1971 and 1982, served as the diversifying asset in the 1970s. Perhaps more impressively, commodities were negatively correlated with both stocks and bonds in more than 50% of the observed periods. We believe that many observers fail to consider in discussions of risk parity that many of the poorest environments historically for bonds represent desirable environments for inflation-sensitive assets like commodities.
It is true that holders of bonds in the 1970s would also have benefited from a higher starting yield — a bond with a higher yield benefits from the fact that the higher interest earnings serve as a buffer to declining bond prices and that higher coupon bonds exhibit lower duration than lower coupon bonds of the same maturity. This means that a unit of exposure to bonds in 1971 would have generated significantly greater coupon income and had less interest rate sensitivity than a similar unit of exposure in 2013. Accounting for this higher yield, risk parity still manages to slightly outperform 60/40 over the 1971-1982 period, producing cumulative returns of 65% vs. the 60/40's 61%.
The risk-parity investor's tools against rising rates are not confined to dynamic allocations, however. In particular, the incorporation of an alternative beta like momentum into risk parity is relatively straightforward, as it can be risk-weighted and traded using the same instruments.
Consider a risk-parity portfolio that allocated one-fourth of risk each to equities, bonds, commodities and a strategy that sold short assets with negative performance and bought long assets with positive performance over the prior 12 months. The momentum allocation results in overweighting those asset classes that are appreciating and underweighting those asset classes that are declining.
The incorporation of momentum introduces an improvement to returns in the 1971-1982 period even after adjusting for the currently low level of interest rates, producing cumulative returns of 285% vs. 61% for the 60/40 portfolio. Put another way, shrewd risk-parity investors can potentially benefit from the sustained poor performance of bonds by incorporating alternative betas alongside traditional market betas.
There are entirely sensible reasons to have long-term concerns about bonds in light of current interest rate levels, and given the historical tendency of risk parity strategies to have large positions in bonds, the concern for risk parity in a rising-rates regime is understandable. Evidence from the last rising-rate environment indicates, however, that critics of risk parity possibly understate the potentially diversifying influence of commodities in these periods, the responsiveness of risk parity strategies to changes in asset volatility and correlations, and the value of introducing alternative betas like momentum strategies into a risk parity framework.
Roberto Croce is director of quantitative research, Rusty Guinn leads the portfolio management group and Lee Partridge is chief investment officer of Salient Partners LP, Houston.
