Risk Parity vs. Brexit: The Rebuttal

Losses incurred on June 23 were an outlier and not a portent of more difficulties ahead, managers say.

Risk parity managers have hit back at an analysis that questioned the strategy’s suitability at times of extreme market stress.

“There is no magic... that is going to camouflage that it was an outlier day for all asset classes.”A report by Markov Processes International (MPI) analyzed risk parity fund performance in the immediate aftermath of the UK’s vote to leave the European Union. It claimed that several major funds had incurred one-day losses near to or in excess of 95% of their value-at-risk measures.

In its report, MPI told investors to “be wary of the types of events to which risk parity funds are calibrated to adapt. What we just experienced could very well be the beginning of a new cycle of volatility surprises.”

“There is no magic in any particular choice of asset allocation that is going to camouflage that it was an outlier day for all asset classes,” Jeff Knight, global head of investment solutions at Columbia Threadneedle Investments, told CIO. He added that it “seemed weird” that MPI had not compared risk parity performance with other asset classes and funds.

Knight—who helped build Putnam Investments’ risk parity strategy before moving to Columbia Threadneedle in 2013—said MPI’s proxy risk parity model used in the analysis made assumptions that were “not true for all funds.”

Mike Mendelson, principal at AQR and manager of its risk parity fund, questioned MPI’s assertion that strategies had been ramping up exposure to risky assets immediately before the vote on June 23. MPI’s proxy risk parity model indicated that, as market volatility fell in the weeks leading up to the vote, the strategy should have increased equity exposures, but the AQR principal said managers rarely recalibrate risk models on a daily basis.

“MPI created a model that they thought mimicked what risk parity does,” Mendelson said. “Everyone uses their own model—our model doesn’t work like that. My understanding from people we talk to and from investors is that it’s more likely that [risky] positions actually declined. Volatility may have declined but risk hadn’t.”

June 24—when global stocks fell sharply on news of the referendum result—was “not extraordinarily bad” for AQR’s strategy, Mendelson added. In the days and weeks after, any losses were mitigated by strong fixed income performance and stock market recoveries, he said.

“What really got hit was sterling, and typically risk parity strategies don’t have direct exposure to currency,” Mendelson said. “Typically they will always have UK-listed stocks but are currency hedged.”

Despite his concerns about MPI’s findings, Columbia Threadneedle’s Knight said the firm was “worried about the right thing.”

“Are there environments in which risk parity is a demonstrably inferior way to do asset allocation?” Knight said. “We’ve seen these environments show up in flashes, for example when everything draws down at the same time, like the taper tantrum.”

June 23 aside, risk parity funds have in general experienced a strong year for performance, bouncing back from a turbulent 2015: AQR’s risk parity mutual fund was up 4.4% in June and 10.9% in the first half of 2016, according to its factsheet.

Related: How Brexit Surprised Risk Parity & Cliff Asness Defends Risk Parity

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