Chinese investors could be set to take their first serious look at risk parity just as the end of a multidecade bull market in sovereign bonds threatens to undermine the strategy's potential returns.
Not to worry, risk-parity managers say.
Managers acknowledge that a market environment where bond yields spike would be a challenging one for risk-parity strategies, which lever up fixed income and commodity exposures to bring their contributions to portfolio risk in line with that of equities.
But see few signs of such a scenario transpiring anytime soon.
In the event of a gradual rise in interest rates from current extremely low levels, risk-parity strategies should still be able to outperform a traditional 60% equities, 40% fixed income mix, they predict.
“For sovereign debt to be a big loser” in risk-parity portfolios, “we'd have to see sharply rising inflation … which we consider highly unlikely over the next 24 months,” said Max Darnell, managing partner and chief investment officer with Pasadena, Calif.-based First Quadrant LP.
Instead, today's low bond yields are consistent with expectations of low returns for conventional risky assets around the globe, said Mr. Darnell, adding that a sharp decline in equity markets is more likely over that period than a rapid pickup in inflation.
The notion that bond yields will rise because current levels are so low has been “very strong, very persistent and so far, very wrong,” noted Michael Mendelson, a principal with Greenwich, Conn.-based AQR Capital Management LLC.
The key question now is whether expectations that yields will rise are so strong that market players choose to “become undiversified” by dumping bonds, said Mr. Mendelson. On that score, risk-parity managers opt for “humility” — relying on the power of diversification to be their guide, rather than making bold market forecasts, he said.
In recent years, risk-parity managers have had more than one occasion to exercise their humility.
In May 2013, risk-parity strategies were stung badly when investors around the world stampeded out of stocks and bonds following Ben Bernanke's first hint that the U.S. Federal Reserve's quantitative easing policies wouldn't last forever.
In 2015, meanwhile, it was a sell-off in global commodity prices that dragged down risk-parity strategies.
With commodities, emerging markets equities and other recent losers all rebounding in 2016, this has been a banner year for risk-parity strategies so far.
And the start of a prolonged stretch of declining bond prices — and rising bond yields — won't necessarily rain on risk parity's parade, managers say.
Mr. Mendelson's fellow AQR Principal Gregor Andrade, who oversees the firm's overseas business, said AQR's back tests on risk parity showed the strategy would have outperformed a traditional 60-40 strategy over the last bond bear market between 1947 and 1981 about as much as it has over the bull market that began in 1981.
When rates spiked during the 2013 “taper tantrum,” the strategy did poorly relative to a 60-40 portfolio, but “those effects tend not to linger” after investor expectations regarding risk assets reset, said Mr. Andrade.
Jesse Huang, Boston-based director of strategic relations with PanAgora Asset Management Inc. and leader of the firm's business efforts in Asia, agreed, noting his firm's risk-parity strategy “bounced back right away,” more than recovering its taper tantrum drawdown over the subsequent 12 months.”
“As long as there is a rate differential between the short end and the long end on the yield curve,” risk-parity strategies will be able to make money, he said.
AQR's Mr. Mendelson said for the most part, institutional clients use risk parity “to become less concentrated in equities.”
There are circumstances where risk parity will underperform a traditional portfolio and many circumstances where it will outperform, resulting in diversification and risk-adjusted returns that are “a little bit better” — a “very powerful” combination, he said.
