Risk parity still can offer rewards to careful investors

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.

For example, in 20% of the 10-year periods we studied, a 60/40 strategy failed to beat cash by two percentage points year. In those cases, stocks posted poor long-run results, so the 60/40 was bound to disappoint. In contrast, risk parity, which spreads its risk across a wide range of investments, rarely posted such poor results. In fact, risk parity failed to beat cash by two percentage points in only 2% of the 10-year periods we studied. So, risk parity has historically delivered higher and more reliable long-term growth.

A dynamic approach to risk parity can help. Some risk-parity strategies allocate risk equally across major asset types no matter what the market environment. The rationale is that it's too hard to predict risk and return. We think this approach is myopic — and a mistake. Sure, it's tough to predict bond returns, but it seems reasonable that when Treasury yields are merely 1.6% and the yield curve is relatively flat (as was the case in mid-2013), the risk premium is likely well below normal and risk is likely negatively skewed for bondholders.

Our analysis indicates that being able to dynamically adjust the strategy's asset allocation makes sense from both risk and return vantage points. Applying simple valuation and adaptive risk tools across asset classes has historically been a big help in generating returns and managing downside risk. A dynamic risk-parity strategy added 1.7 percentage points per year over a static risk-parity approach (Exhibit 2). And it nearly doubled the risk-parity advantage over a 60/40 portfolio. About two-thirds of the benefit came from using dynamic risk and the rest from simple dynamic return signals. So, we think investors should consider including both in their portfolio.

We believe the timing for investing in risk parity has improved. Some investors feel that the risk parity underperformance is still in its early stages. We disagree. By the end of 2013, bond yields had risen and yield curves had steepened. Also, commodity markets sold off and many commodity futures curves were in “backwardation” — prices on futures contracts were lower than spot-market prices, providing an avenue for commodity futures to deliver returns.

Finally, equity markets had rallied substantially and valuations no longer seemed cheap.

We think all of this bodes well for future risk-parity returns. Over the past 100 years, periods of sharp sell-offs in bonds or commodities have typically led to strong performance for risk-parity strategies, as diversifying assets cheapened and return prospects improved. On average historically, after underperforming in sell-offs, risk parity has gone on to outperform for several quarters.

Diversifying across manager strategies might improve performance. Risk parity continues to evolve as an investment approach. More managers have entered the space, and the types of strategies they employ are evolving, too. That's a good thing: it provides more choice and potential diversification for investors. From our perspective, strategies that can be dynamic — incorporating research and manager judgment in setting risk allocations — are an important advancement.

Despite the concern over risk parity, we believe we're looking at a bump in the road. As the risk-parity space continues to develop, we think investors should consider diversifying across a range of complementary risk-parity managers, just as they would with any other part of their allocation. n

Daniel J. Loewy is chief investment officer and co-head — multiasset solutions, and Brian T. Brugman is portfolio manager — multiasset solutions, at AllianceBernstein in New York.