Risk Parity: All-Weather Risk Reduction Strategy

All-Weather Risk Reduction Strategy

Risk-parity investment portfolio strategies, which are also called "all-weather" strategies, were developed as far back as the 1950s while the first risk parity fund, called the All Weather fund, was launched in 1996 by hedge fund manager Ray Dalio. These strategies can be applied at an individual portfolio level as well, although it is advisable with the help from an investment professional.

Risk-parity strategies became more popular during the 2007-2009 financial crisis when they provided better returns than many mutual funds, whose portfolios were constructed according to traditional asset allocation structures. The “all-weather” approach focuses on allocation of risk, as opposed to allocation of capital as in the traditional approach.

The risk parity approach divides risk equally across the entire portfolio while traditional allocation methods are based on holding a certain percentage in asset classes, such as stocks, bonds and cash.  In a typical balanced 60/40 stock/bond portfolio, up to 90% of the risk is derived from the stock portion and thus, the portfolio's returns are depend on equity returns.

Risk parity considers four asset classes: stocks, bonds, money market and commodities, and tries to spread risk evenly across each of them. In most cases, the risk approach leads to a bigger share of bonds. The goal of this approach is the same as for most investment strategies: to improve the risk/return ratio which means to earn the same level of return with less risk or to obtain better returns with the same risk. At the same time, it is perceived that the 60/40 stock/bond approach performs better during bull markets while the risk parity approach does better during bear markets.

Josh Charlson, director of alternative funds research at the investment research firm Morningstar, put this perception to test and looked at the risk-parity mutual funds performance in 2013. He found that risk-parity funds underperformed amid the bull market of 2013 (see the table). Every fund, which Morningstar considers to be risk-parity, had a return below 5% or even worse and badly lagged behind their respective benchmarks.

These results are understandable, given that only about a third of the strategy's risk is allocated to stocks. However, these funds last year lagged behind a 60/40 strategy which it is supposed to replace. They also lost the race to the average world-allocation and tactical-allocation funds which belong to the same categories into which risk-parity funds are placed.

As many investors are getting worried about the future of the stock market this year, it would be interesting to find the reasons for the poor performance of risk-parity funds in 2013. The main reason was that two of the three major asset classes in most risk-parity funds, bonds and commodities, showed low or negative results last year. Risk-parity funds’ exposure to bonds played a disservice when the bond market fell last year due to expectations of the Fed lessening its quantitative easing program. Commodity prices were flat to lower last year.  In particular, the Dow Jones-UBS Commodity Index lost 9.5%.

On the back of this kind of underperformance, many investors are redeeming their positions in risk-parity funds. According to Josh Charlson, the outflows from Invesco Balanced-Risk fund reached nearly $1 billion in January-February 2014.

Selected Performance Statistics of Risk-Parity Mutual Funds

	Morningstar Category	2013 Total Return
AQR Risk Parity N	Tactical Allocation	-0.23%
Columbia Risk Allocation A Load Waived	World Allocation	-6.16%
Invesco Balanced-Risk Allc Y	Tactical Allocation	2.29%
Managers AMG FQ Global Essentials Svc	Tactical Allocation	-2.03%
Putnam Dynamic Risk Allocation Y	World Allocation	3.74%
Salient Risk Parity I	Tactical Allocation	-4.59%
Benchmarks
S&P 500 Total Return		32.39%
60/40 MSCI World/BarCap Agg		14.80%
World-Allocation Category		10.07%
Tactical-Allocation Category		8.62%

Source: Morningstar, Inc. 2014. All data through 12/31/13

Going forward, the situation for these funds could be troublesome, mainly due to the risks from commodities which may have a volatile year ahead. At the same time, Charlson maintains faith in risk-parity funds. At this stage, he suggests to invest a small portion of one’s assets in such funds. He says that most risk-parity funds are new and have not had time to prove themselves in their most advantageous circumstances, i.e. during a bear stock market.

Michael Zienchuk, MBA, CIM

Investment Advisor, Credential Securities Inc.

Manager, Wealth Strategies Group

Ukrainian Credit Union

416-763-5575 x204

mzienchuk@ukrainiancu.com

www.ukrainiancu.com

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