Consider a risk parity portfolio that allocated 1/4 of risk each to equities, bonds, commodities and a strategy that sold short assets with negative performance and bought long assets with positive performance over the prior 12 months. The momentum allocation results in overweighting those asset classes that are appreciating and underweighting those asset classes that are declining.
Incorporating momentum improves returns in the period under consideration even after adjusting for the currently low level of interest rates, producing cumulative returns of 285 percent versus 61 percent for the 60/40 portfolio. Put another way, shrewd advisors can potentially use risk parity to exploit the sustained poor performance of bonds by incorporating alternative betas alongside traditional market betas.
There are entirely sensible reasons to have long-term concerns about bonds in light of current interest rate levels, and given the historical tendency of risk parity strategies to have large positions in bonds, the concern for risk parity in a rising-rates regime is understandable. Evidence from the last rising-rate environment indicates, however, that critics of risk parity possibly understate the potentially diversifying influence of commodities in these periods, the responsiveness of risk parity strategies to changes in asset volatility and correlations, and the value of introducing alternative betas like momentum strategies into a risk parity framework.
Lee Partridge is the Chief Investment Officer of Salient Partners, L.P., a Houston-based investment firm with over $18.5 billion in assets under management or advisement. Roberto Croce is Salient’s Director of Quantitative Research for the Investments Group and Rusty Guinn leads the Portfolio Management Group, which is responsible for managing the firm’s multi-asset relationships and investment funds.