A slowing economy? Rising interest rates? These and other economic factors make it hard to plan how to use risk parity in allocating assets.
Speaking at the Pension Bridge conference in San Francisco, Edwin Denson, managing director of asset and risk allocation at the State of Wisconsin Investment Board ($117 billion), examined the dilemmas of risk parity strategies, which measure risk when figuring out what to invest where.
“Reduction and exposure to risky assets just as they’re declining and haven’t recovered” is one of the potential drawbacks, he said. Another is a “rise in real interest rates,” he said. Sometimes things can easily go awry and a batch of new risks suddenly appear, he suggested.
Example: the 2013 “taper tantrum,” when fixed-income yields shot up as the Federal Reserve unexpectedly announced it would reduce its purchases of Treasury and mortgage bonds. The carnage from falling stock and bond prices, owing to the threatened reduction in Fed stimulus, prompted the central bank to back off that plan
The amount of debt any portfolio carries can affect its returns, Denson said. That even can impact a manager’s ability to sell assets when needed, he added, saying, “liquidity risks can also arise at times when the strategy struggles, again, depending on the amount of leverage that’s employed.”
Another challenge is the lack of a proper benchmark for risk parity. This is due to the wide array of investments located in these types of portfolios, market volatility, and of course, the degree of leverage involved. The Wisconsin official said that, even if the investment community were to agree on a passive benchmark, equity volatility would be an issue.
“It’s hard to imagine there ever being a complete consensus on what volatilities of various asset classes should be in terms of the inputs into a risk parity strategy,” he said.
In a low-return environment, many allocators are wondering if the strategy makes sense, as its goal is more oriented to mitigating crises and downturns than to maintaining a portfolio in times of lackluster returns. While Denson said this is a challenge “in general,” and puts risk parity at a disadvantage, he said fixed-income and inflation-sensitive assets are more likely to suffer from this.
“Risk parity did outperform significantly during the financial crisis and continued to outperform through the European debt crisis,” he said. “However, the strategies have tended to underperform to some degree in the recovery since those two crises.”
Denson expects the same pattern to emerge “in any market crisis that is driven by declines in risky assets,” but does not see the next downturn to be as severe as the financial and European crises. “It’s going to affect all strategies and [is] not contingent on risk parity in any particular way or relative fashion,” he said.