As they survey the investment landscape in search of opportunities for their clients, advisors increasingly have interest rates on their minds. No one knows for sure when it will happen but there is a general consensus that interest rates cannot remain at their current historic lows indefinitely. It is not a question of if rates will go up, but of when.
Many of the younger generation of advisors have never experienced a period with significant and sharp increases in interest rates and are understandably uneasy about the possibility that the removal of the highly accommodative monetary policies adopted by central banks or the inflationary pressures from a continued expansion of the monetary base will trigger such an occurrence. In the face of this uncertainty many advisors know they have to do something with their clients’ bond portfolios, but are anxious about implementing risk parity strategies that may carry leveraged bond positions.
Some advisors may not be familiar with the approach, but risk parity is nothing more than an effort to distribute risk equally across key elements of a portfolio that are not only lowly correlated with one another but also linked in different ways to the main economic drivers—growth, inflation and sentiment. It also entails targeting a consistent level of portfolio volatility regardless of changing market conditions.
For those with less than three decades in the investment arena an historical overview may be helpful. The last stretch of consistent, sustained rises in yields in the United States took place between 1971 and 1982, and an analysis of that period may provide a useful testing ground for addressing the concerns of advisors. For our model we constructed a basic risk parity portfolio consisting of a mix of equities, bonds and commodities that is rebalanced to equal risk on a monthly basis, and looked at risk parity’s performance based on the actual trajectory of yields over that period. Since actual yields in 1971 provided an income buffer to bond returns, we also examined risk parity’s results as if the yield on the U.S. 10-Year Treasury Bond in 1971 was 1.6 percent, in order to approximate the 2013 low.
For much of the 1970s risk parity’s bond exposure, prior to the significant rate increases, would have been high, averaging close to half of the portfolio. This would be an intuitive move for most advisors without even factoring in correlations. Bonds represent a fundamentally less risky asset class than equities and so would nearly always require a larger weight to achieve the same level of risk in a portfolio. Thus, the perception among many advisors is that history is about to replay and that low interest rates together with significant exposure to bonds in risk parity strategies is the forerunner to a period of sharply rising rates and poor returns to those strategies.
An examination of the historical data, however leads to a different conclusion. For the period between January 1971 and December 1981 a simple risk parity implementation would have both generated positive nominal returns and outperformed an allocation strategy with comparable volatility, namely a benchmark of 60 percent equities and 40 percent bonds. Risk parity would have provided a cumulative return of 235 percent, almost double the cumulative return of 118 percent from the 60/40 portfolio.
The Difference Is Dynamic Exposure
The reason traditional static allocation schemes and risk parity implementations behave differently is often ascribed to the use of leverage or to the bias toward lower volatility assets. Often overlooked is the fact that risk parity exposures are intentionally designed to be dynamic, which is truly one of the most important differentiators. When asset class returns become more volatile or more correlated with other asset classes, classic risk parity strategies respond by lowering exposure to the asset classes exhibiting higher volatility or higher correlations with other asset classes. By contrast, traditional, static asset allocation strategies which are not designed to adjust to changing levels of volatility or correlation hold steady. Consider, for example, that stocks and bonds were positively correlated over nearly every rolling 36-month period in this analysis. This means that bonds would have typically been a less prominent asset within most risk parity implementations, something we believe is a reasonable assumption in a future period of rising rates.
In addition to (and often in conjunction with) changes in volatility, correlations between assets change frequently as well. And while this may not often lead to changes in traditional allocation models, it can have a meaningful effect on the positioning of risk parity implementations that rebalance with any frequency. Consider, for example, that stocks and bonds were positively correlated over nearly every rolling 36-month period in this analysis. Relative to the more recent past, this means that bonds would have typically been a less prominent asset within most risk parity implementations.
By way of contrast, commodities, which were negatively correlated with either stocks or bonds over 97 percent of rolling 36-month periods between 1971 and 1982, served as the diversifying asset in the 1970s. Perhaps more impressively, commodities were negatively correlated with both stocks and bonds in over 50 percent of the observed periods. We believe that many observers fail to consider in discussions of risk parity that many of the poorest environments historically for bonds represent desirable environments for inflation-sensitive assets like commodities.
One advantage that bondholders of the 1970s had over today’s investors is the benefit of a higher starting yield – a bond with a higher yield benefits from the fact that the higher interest earnings serve as a buffer to declining bond prices and that higher coupon bonds exhibit lower duration than lower coupon bonds of the same maturity. This means that a unit of exposure to bonds in 1971 would have generated significantly greater coupon income and had less interest rate sensitivity than a similar unit of exposure in 2013. Accounting for this higher yield, risk parity still manages to slightly outperform 60/40 over the 1971-1982 period, producing cumulative returns of 65 percent versus the 60/40’s 61percent.
We believe advisors implementing risk parity have more tools available to guard against rising rates than simply dynamic allocations. In particular, the incorporation of an alternative beta-like momentum into risk parity is relatively straightforward, as it can be risk-weighted and traded using the same instruments.