Risk Parity Smiles Through Market Correction

Risk parity powerhouses on why the strategy delivered on its promises during the recent days of stock markets crashes and rallies.

This week’s dramatic volatility in US stock markets has created plenty of anxiety, but for one sector of asset management—risk parity—it’s been an opportunity to shine.

“This is why we do this,” Jeff Knight, Columbia Threadneedle Investment’s global head of investment solutions and asset allocation, told CIO. “The merits of risk parity as a volatility-stabilizing strategy have been evident in this turmoil.”

The fundamental premise of risk parity—that concentration of risk, particularly in domestic equities, can be dangerous—is becoming increasingly important, Knight argued. 

With less exposure to equities than a traditional 60/40 portfolio, risk parity strategies are likely to experience lower volatility and vulnerability to potential dramatic underperformance, he added. 

“The merits of risk parity as a volatility-stabilizing strategy have been evident in this turmoil.”Furthermore, risk parity may be better positioned to deal with choppy stock markets, thanks to rising risk premiums, according to Bridgewater Associates Co-CIO Bob Prince.

Returns for the firm’s All Weather strategy were comparable to that of a traditional portfolio so far this year, Prince said, “because the main driver of asset returns has been a moderate rise in risk premiums, which impact both a balanced portfolio and the traditional mix similarly.” 

“Going forward, if equities fall due to weaker growth, this would have little impact on our All Weather portfolio, and we would be earning the higher risk premiums which now exist,” he added.

Knight also emphasized the importance of striking the balance of harnessing risk premiums and avoiding drawdowns. 

“If there is a ‘dip’ to buy, risk parity would offer a more compelling menu of opportunities across assets,” he argued. “The real power of this strategy is that there’s a chance to exploit that efficient participation in risk premiums. But at the end of the day, risk parity is a risk-taking strategy. Investors ought to expect periods where you make money and periods where you see drawdowns.”

“Going forward, if equities fall due to weaker growth, this would have little impact on our All Weather portfolio, and we would be earning the higher risk premiums which now exist.”Indeed, the past 12 months overall have not been friendly for risk parity. 

According to consulting firm Redington’s July report, risk parity lost 5.4% in the year ending June 30—using Salient’s risk parity index—second only to commodities in terms of poor performance.

“Risk parity is a long-only strategy that is designed to deal with market volatility,” said Scott Wolle, Invesco’s CIO for global asset allocation. “We’re not too worried about the stock market in the short term. We have other parts of the engine firing to cushion drawdowns in down markets.”

The same Redington report also found risk parity was a top performer over the 10 years to  the end of June, with a 6.7% annualized return and Sharpe ratio of 0.64. 

“Risk parity investors think they can do the same or better than the 60/40 portfolio over long periods of time, but without the wild ride,” NEPC’s Kristin Reynolds said. “We saw that this year—though returns have been negative—and particularly in the last couple of days.”

Related: Risk Parity’s Annus Horribilis

By Sage Um

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