Jeffrey L. Knight, Columbia Threadneedle Investments' global head of investment solutions, says he is at turns happy and frustrated with how his Columbia Adaptive Risk Allocation fund has fared during a challenging period for risk-parity strategies this year.
In a recent interview in Singapore, Mr. Knight said considering the market environment this year — with sharp drawdowns for energy-linked investments, commodities and emerging markets equities tripping up a broad range of multiasset and risk-parity strategies — CARA's drop of 1% or 2%, after a 10% gain for the strategy's first full year in 2014, counts as “quite a good year for us. … I'm actually quite satisfied.”
On the frustrating side, Mr. Knight said a wave of criticism this year of risk-parity strategies — which leverage up exposure to lower risk assets, such as bonds, to narrow the gap between their contributions to overall portfolio risk with that of equities — has caused many institutional investors to hesitate in “adding risk-balanced or risk-parity managers to their manager stable in 2015.”
While CARA's assets from retail investors have climbed to roughly $450 million currently from $100 million a year before, on the institutional side conversations with clients are “still in a seasoning process,” even if there remains widespread interest in the way the strategy is structured, Mr. Knight said.
Like other risk-parity strategies, CARA uses leverage to more efficiently balance the risk contributions of different asset classes, but with a rules-based methodology that adjusts that balance for four different sets of economic conditions: from a bearish “capital preservation” state at one end, where leverage is removed and bonds dominate the portfolio, to a “highly bullish state” at the other end, where equities and inflation-linked investments dominate and leverage boosts market exposure to 175% of underlying assets.
If the most famous risk-parity brand is Bridgewater Associates LP's All Weather strategy, Mr. Knight said CARA “takes its sweater off in the summer and puts a coat on in the winter.”
For an unconventional strategy such as CARA, a “longer selling process” was always to be expected, Mr. Knight said. Still, he acknowledged being a little disappointed that a broadside of criticism directed at risk-parity strategies this year, occasioned by their underperformance, had effectively raised the hurdles for institutional investors considering those strategies.
While conceding he might not be entirely objective, Mr. Knight said he finds the two main arguments by critics this year: The first, that negative performance for 2015 validates a rejection of the strategy as one that relied on a 30-year bond rally — now ended — for its successes until now, and the second, that leverage employed by risk-parity strategies is undermining the broader market — as lacking in substance.
Those critics seemingly believe that risk parity has staked its value proposition on being immune to losses over any period of time. Instead, the strategy should be seen as an efficient way to capture risk premiums over longer time periods, making it highly premature to consign it to the dust heap of investment history on the basis of a three- or six-month setback, Mr. Knight said.
Risk-parity strategies have indeed underperformed in 2015 but, after a period earlier this year where nothing looked cheap, a case can be made now that pockets of opportunity have emerged again — perhaps in credit markets or emerging markets equities — and risk-parity strategies will provide a balanced, efficient means of capturing those risk premiums, he said.
Meanwhile, the recent underperformance has had “nothing to do with bonds,” which have been the best performing part of risk-parity portfolios this year, Mr. Knight said.
Mr. Knight said he doesn't mean to imply that all criticisms of risk parity are without merit. “The whole reason we developed CARA was because we embrace some of those same concerns about the vulnerabilities” of the strategy, he said.
But the wholesale rejection of risk party “is not well supported by theory or evidence … even now, when you have a year like this,” he said.
Recapping CARA's positioning for 2015, Mr. Knight said the strategy remains in “neutral” — with roughly 50% exposure to equities, with the remaining exposure equally divided among interest rates, inflation hedging and spreads, and leverage raising overall market exposure to 150% of underlying assets.
While some observers have asked why the volatility in the third quarter didn't push CARA into capital preservation mode, Mr. Knight said, among other factors, the U.S. bond market, where the yield on the benchmark 10-year Treasury bond remained well above 2%, wasn't flashing danger signals. The equity market's bounce in October, meanwhile, effectively justified the decision to remain in stocks, he added.
CARA “isn't meant to jump around and reposition every month perfectly,” Mr. Knight said. Rather, “it's meant to handle things on average,” he said.
Despite the public debate about risk parity, Mr. Knight said the conversations he's had on his latest Asia trip, which took him to Beijing, Seoul and Singapore, have suggested a high degree of continued interest in CARA, in particular, and risk parity in general.
He pointed to that general interest as a particularly good thing. “I think my commercial opportunity has to do with a much wider embrace of the risk-parity mindset in all of its forms, as opposed to a rejection of it in all of its forms,” so the feedback from asset owners on this trip was reassuring, Mr. Knight said.