Risk-parity portfolios weather spike in yields

Risk-parity strategies are emerging relatively unscathed from the Donald Trump era's initial spike in Treasury yields, a market move some had seen as a potential Achilles' heel for portfolios with leveraged bond exposures.

In the final quarter of 2016, the yield on benchmark 10-year Treasuries jumped to 2.445% from 1.597%, after the election of a celebrity real estate mogul promising a return of the U.S. economy's salad days.

A prolonged bear market for bonds — following a 30-year bull market — had been seen as a dangerous scenario for a strategy that leverages exposure to bonds to bring their contributions to total portfolio risk in line with that of equities.

But managers said the fallout proved less than devastating.

“Bonds got crushed” in the fourth quarter but equities and commodities did OK, said Michael Mendelson, a principal with AQR Capital Management LLC and a portfolio manager for the Greenwich, Conn.-based firm's risk-parity strategy. While AQR's risk-parity strategy ended the year off its intrayear highs, “all in all, it held up really well in a really terrible bond market,” he said. He declined to provide performance numbers.

Robert Job, head of business development and client solutions with Boston-based PanAgora Asset Management Inc., told a similar story. His firm's risk-parity strategy — which accounts for roughly a quarter of PanAgora's $40 billion in assets under management — gave back roughly 3 percentage points of gains in the fourth quarter but still ended the year up 13%.

Risk-parity allocations have “weathered the jump in yields amazingly well,” said Robin L. Diamonte, vice president and chief investment officer of United Technologies Corp.'s $24.8 billion pension fund. Seven percent of those assets are allocated to risk-parity managers, including AQR and Bridgewater Associates LP.

“Our worst-performing manager was down just a little more than 2% in the fourth quarter,” making risk parity the fund's third-highest returning asset class in 2016 — an “outstanding year” for the strategy, she said.

Still, Ms. Diamonte said her team is now “in the middle of a project” analyzing how expectations of higher growth, faster interest rate hikes and stronger inflationary pressures could affect the role risk-parity strategies play in UTC's broader portfolio.

A growing minority of risk-parity managers say their strategies are designed to tweak exposure to bonds depending on whether the economy looks set to wax or wane.

“The new class of risk-parity strategies that respond to changing market conditions” — like Columbia Threadneedle Investments' Columbia Adaptive Risk Allocation strategy — could prove well suited to the current environment's uncertainties, said Jeffrey L. Knight, Boston-based global head of investment solutions and co-head of global asset allocation.

In August, the CARA strategy shifted to a “highly bullish” market state, the most growth-oriented of four potential states. Under that strategy, exposure to bonds is largely eliminated.

While that move left Mr. Knight “a little uneasy” in the runup to the U.S. presidential election, it “turned out to be well founded,” he said.

Edgar Peters, partner, investments with Pasadena, Calif.-based First Quadrant LP, said his firm's risk-parity strategy also adapts, depending on whether its market risk indicator shows the economy to be “resilient” or “fragile.”

Bonds offer a trio of advantages — diversification, tail-risk hedging and deflation hedging — in a weak or fragile economy. But in a strong economy, in which a pickup in inflation can cause bonds to sell off, First Quadrant's strategy can use credit for diversification and options to hedge tail risk in lieu of bonds, said Mr. Peters.

Since August, First Quadrant's risk-parity strategy has been “in the resilient state,” with the strategy's market risk indicator showing bond risk to be much higher than equity risk, said Mr. Peters. “So we are not leveraged bonds,” he said.

Mr. Peters said the firm's risk-based portfolio edged down 0.81% in the last quarter of 2016 but still managed a return, gross of fees, of 14.48% for the year. For the first month and a half of 2017, the strategy is up more than 3%, he said.

Risk-parity managers say continued uncertainty about what policies Mr. Trump will pursue and what their impact on the economy will be should further bolster the case for the strategy now.

After years of clearly defined policies, “we are entering a period where there's going to be changes,” with plausible scenarios that could lead to either improved growth or economic contraction, said AQR's Mr. Mendelson. “This year it's really a crap shoot” — an environment in which investors should not be making “heroic market calls,” he said.

“The story here is not about whether one asset in the portfolio might or might not suffer (but) how you prepare for a wide variety of outcomes,” said Max Darnell, First Quadrant's managing partner and chief investment officer.

With a critical mass of uncertainties today ranging from political leadership and policy to regulation and trade, “anyone who says they know how this will play out is fooling themselves,” said Mr. Darnell.

PanAgora's Mr. Job said critics of the strategy often focus on one component, such as nominal interest rates, instead of the broader approach of spreading risks equally among equities, as a growth proxy; bonds, as a proxy for contractionary conditions; and commodities, as a proxy for inflation.

AQR's Mr. Mendelson agreed. “Risk parity isn't a defensive strategy. It's a risk-taking strategy but one that says "I don't know'” which risk will pay off, he said.

For 2016, all three legs of the risk-parity stool contributed positively, something that's hard to expect for the current year, said Mr. Mendelson. “But we don't need everything to be positive,” as decent growth with some inflation could continue to offset bond-related losses, he said.

Some investors see the potential for a less positive outcome for risk-parity strategies this year. Charles Van Vleet, CIO of Textron Inc.'s $6.3 billion defined benefit plan, said if rates rise due to growth, then the equity and commodity legs of a risk-parity strategy can offset any bond losses. But if rates rise due to inflation rather than growth, the math looks worse, he said in an email. If Mr. Trump emphasizes the protectionist part of his campaign program, that stagflation scenario will loom larger, said Mr. Van Vleet.