How Brexit Surprised Risk Parity | Chief Investment Officer

Risk parity strategies were hit hard by the fallout from the UK’s referendum on European Union membership, data show—and they could be caught off guard again.

Such funds loaded up on equities and other risk assets immediately prior to the referendum on June 23, according to analysis by Markov Processes International (MPI). This left risk parity investors exposed to the spike in volatility that followed the vote in favor of Brexit.

“The volatility prior to the vote in risky asset classes not only decreased, but decreased more than fixed income, a traditionally safe haven during periods of crisis,” MPI’s report stated. As risk parity strategies favor low-volatility asset classes in order to balance out risk across their portfolios, “more responsive” funds shifted allocations towards equities, MPI said.

“This suggests that any anticipation within the markets of the dramatic sell-off did not surface in shifts in volatility,” the report said. “In fact, risk parity portfolios were being positioned for an appreciation of risk assets.”

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A number of funds experienced losses close to, or higher than, their stated maximum value at risk measure.

Risk parity fund returns post-Brexit Performance of risk parity funds on June 24 following Brexit.

Last August risk parity funds were blamed by some investors for contributing to sharp sell-offs, as they are more likely to reduce equity exposure during periods of high volatility. A number of products performed poorly in 2015, but prior to the UK’s referendum they had in aggregate recouped most of the losses incurred during 2016.

AQR Co-Founder Cliff Asness argued in December that investors should not be put off by short-term performance. “Drawdowns in real life always seem to feel longer and induce more pain than you’d imagine looking back,” Asness said. “This is true for risk parity and all of investing.”

MPI warned that a short period of positive performance was equally no reason for investors to “let their guard down.”

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

The value factor is the only form of smart beta currently trading at an attractive valuation, according to Research Affiliates.

“Valuations of many of the most popular factors and smart beta strategies are well above historical norms.”Pricing of factor indexes relative to history matters to investors “every bit as much as they matter when choosing managers, funds, and individual stocks,” wrote Chairman Rob Arnott, Quantitative Researcher Noah Beck, and Head of Equity Research Vitali Kalesnik.

“Today, valuations of many of the most popular factors and smart beta strategies are well above historical norms,” the authors stated, citing their own analysis of historical valuations of eight factor indexes and eight strategies. “We have demonstrated that these high valuations are indicative of lower future returns, even if they are not able to provide any prescience on picking peaks or troughs.”

Value-tilted strategies are currently unpopular with investors and as such are “considerably cheaper than historical norms,” the authors wrote.

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However, momentum, illiquidity, and low-beta strategies are all trading near their historic peak valuations, Research Affiliates’ analysis found. Equal-weighted and quality indexes are also near all-time highs outside of the US markets.

These are among the factors attracting the most money from investors, Arnott, Beck, and Kalesnik said, which they argued was “dangerous.”

In addition, the authors warned against reading too much into their findings.

“We would offer a word of caution to those who wish to use these findings to aggressively time strategies,” Arnott, Back, and Kalesnik wrote. “Timing strategies leads to greater concentration of risk, so lacks diversification. A noisy signal and weak ability to diversify is a recipe for disappointment.”

Read the Research Affiliates paper, “To Win With Smart Beta, Ask If the Price Is Right.”