What is risk-parity investing?
Risk-parity investing looks at a portfolio’s variability–and the cause of that volatility—and says: maybe we can do better. It focuses on the allocation of risk rather than the allocation of capital. It uses borrowing to do this, but it asserts that when asset allocations are either levered up or levered down to the same risk level, an optimum combination can achieve higher returns per unit of risk and be more resistant to market downturns than a traditional portfolio. The performance of a number of risk parity funds during the financial crisis and its aftermath have made it quite popular now with investment consultants and the asset allocation industry.
In a nutshell, the thinking goes like this. In a traditional 60% stocks / 40% bonds portfolio, 90% of the risk comes from the equity side. That is, the bonds are pretty stable, and the stocks jump up and down. If you take some bonds—like Treasury, Corporate, and Mortgage-Backed bonds—and lever them up, you can achieve stock-like risk, but the returns will be higher. And if you take stocks and lever them down—combine stock holdings with cash—their risk will be lower. Then, using optimization software, the assets are combined to achieve the desired risk level, and returns are—hopefully—enhanced.
This approach has done quite well in recent years as interest rates have fallen and stocks have languished. Since the internet bubble popped, equities have gone sideways—with a big hiccup in the middle—while bonds have boomed. But risk parity investing confuses cause with effect. Investment returns don’t come from risk; investment returns come from participating in an economy’s capital structure. Bonds will always be senior to stocks; but their returns will vary based on the challenges an economy faces and investor psychology: just look at what happened in the ‘70s!
Correlation is not causation, and capital confusion is stupid. Levered bonds portfolios have excelled as rates have gone to zero, but all the optimization software in the world won’t repeal the law of gravity: what goes up must come down. When rates come back, a lot of backward-looking optimizers will look pretty foolish.
Douglas R. Tengdin, CFA
Chief Investment Officer
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