After tremendous growth over more than a decade of strong returns, risk-parity strategies recently have been struggling. Has the market run-up exposed a fatal flaw? We don't think so.
Risk-parity strategies seek to diversify across asset classes not by concentrating on market-value exposures, but by balancing the risk contributions of the major assets to a portfolio.
This strategic focus on diversification leaves risk parity structurally underweight equities and overweight other return drivers — such as bonds, credits and commodities — compared with a traditional allocation. That caused risk parity to lag in 2013, as the equity bull market strengthened and many diversifiers underperformed.
This has many investors wondering if the recent environment exposed vulnerability in risk-parity design or simply created a short-term bump in the road toward higher risk-adjusted returns. In our view, risk-parity strategies still warrant an increasing role in investors' portfolios.
We researched capital markets going back over 100 years of data, from Dec. 31, 1909, to Dec. 31, 2013. This analysis highlighted a persistent benefit from risk-parity investing over investing in a traditional 60%/40% stock/bond mix. We believe this advantage will reassert itself over time.
Our research highlights four things for investors to keep in mind when evaluating the role of risk parity in their asset allocations:
In the long run, diversification should win. Risk parity can trail a 60/40 strategy over any short period of time, particularly when stocks flourish. But the 60/40 advantage isn't likely to last. Over individual quarters or years, risk parity outperforms 60/40 about 55% of the time. But over five-year or 10-year periods, risk parity wins more than 70% of the time (Exhibit 1). As the time horizon grows, risk-parity performance is not only likely to be higher than 60/40 performance, but far more consistent.