Risk-parity approaches to asset allocation, whereby investments are structured in a balanced way so that all asset groupings are expected to contribute equally to portfolio volatility, have received much attention in the past decade.
Approximately $150 billion in assets are held within asset management strategies that generally encompass the risk-parity universe. Risk-parity approaches can deliver many positive attributes, including superior diversification than is typically expressed within traditional institutional asset allocation policies. In this regard, risk parity can assist in managing against drawdown risk, as the strategies' pursuit of balance across market cycles can dampen portfolio vulnerability to specific economic and market regimes.
Despite the flow of assets into risk-parity strategies and the elevated level of attention they've attracted, many investors who have considered the approach have chosen not to deploy assets. There is a variety of reasons an institution might not find risk parity appropriate for meeting their organization's specific objectives, but the impediment most frequently cited is the current low-yield environment and concerns that interest rates are likely to rise in the future.
Because spreading risk equally across asset classes leads to larger relative weights to lower-volatility assets and smaller relative weights to more volatile assets, the resulting allocation mixes tend to produce portfolios with both low expected returns and risk. The typical risk-parity strategy therefore applies modest levels of leverage to these mixes to deliver them at return and risk levels intended to meet institutional return needs. When compared to traditionally diversified portfolios, which tend to have heavy risk concentration in growth assets such as public and private equities, risk-parity strategies tend to hold larger positions in high-quality fixed-income securities. It is this relative increase in bond exposure and its subsequent vulnerability to a rising rate environment that has discouraged many from investing in risk-parity strategies, even those that find the general asset allocation philosophy compelling.
While we disagree with the occasional assertion by some that risk-parity strategies are essentially levered bond strategies (they are better understood as leveraging of balanced low volatility asset mixes), we do understand concerns over increased exposure to yield-sensitive assets such as high-quality bonds. Further, while we do not think that there is ever a “bad time” to move toward greater diversification, the direct inverse relationship between yield shifts and fixed-income returns over the short term can make an increased exposure to bonds unsettling for investors who believe that interest rates will rise beyond the levels priced into fixed-income markets.
Investors concerned with the prospects of rising interest rates should consider a traditional glidepath approach to manage a transition of assets from today's allocations toward a suitable exposure to risk parity. This migration plan is appropriate for investors who appreciate the potential benefits of a risk-parity investment approach yet find themselves paralyzed from taking action in fear of rising yields. If concerns over an increase in rates are the true investment impediment, why not take that issue head on and enact a transition plan that directly manages against that risk?