In the topsy-turvy days after the election, Chief Investment Officer’s Managing Editor Sage Um spoke with Jeff Knight, Global Head of Investment Solutions and Co-Head of Global Asset Allocation for Columbia Threadneedle Investments, on the current market environment and the implications for risk parity strategies. Q: Risk parity strategies have done well in 2016. What has been the driver of that return? Do you think that the strategies can continue to perform well given the changes that we are seeing in the markets? Jeff Knight: For risk parity investors, the power of diversification was employed to an advantageous effect in 2016. Bonds, particularly high-quality, interest-rate-sensitive bonds, performed as diversifiers when we saw losses in equities, and investors saw strong performance from diversifying assets like high-yield, commodities, and emerging markets stocks and bonds. After a year like 2015, when it seemed like a more diversified portfolio translated to worse results, it was gratifying to see diversification providing a strong benefit to investors again. Going forward, much depends on the building blocks of risk parity: if they were to move down in a correlated fashion, we could see these strategies struggle again. More likely, I think, is an environment where the variety of prospective opportunities presented to investors demands a more flexible implementation than a mechanical static approach. That is why I think it can be very helpful to incorporate a dynamic or an adaptive element in a risk parity strategy. Q: Could you give us an example of when an adaptive element may be necessary? Knight: Right now. The twin forces that have powered global stocks higher over the last seven years have been monetary stimulus and policy gridlock. The election appears to have changed both, at least in the United States. Economic policy since the Great Financial Crisis has relied on the toolkit of zero-interest rates and quantitative easing. Given the Republican Party sweep in the US election, it has become feasible to incorporate other elements, like infrastructure spending and tax reform, into the policy mix. If it works, this policy inflection could lead to higher nominal growth, which may help stocks, but creates an unfavorable environment for bonds. In this scenario, we might prefer a more concentrated and a more risk-oriented investment strategy over a strategy focused on balancing risks evenly. Q: Are these types of events the rationale for Columbia Threadneedle’s adaptive risk allocation strategy? Knight: Yes. At a high level, the adaptive strategy employs a balanced risk approach when that makes sense, but we are not trying to balance risks evenly across assets at all times. We are trying to configure risks prospectively in the most advantageous way. If a particular risk, like interest-rate risk, is unattractive in a cross-sectional comparison of opportunities, there is no reason to give it equal prominence. It is hard to come up with a better approach than risk parity as an allocation strategy in my view, but that does not mean that risk parity is infallible or does not have moments of sub-optimality. Q: What are the characteristics of these sub-optimal environments? Knight: Risk parity strategies rely on risk balance and leverage to deliver efficient returns, and there are two conditions that undermine the optimality of a parity approach. One of them is when the building blocks of the strategy present a lopsided risk/return opportunity. A central premise of risk parity is that, in the long run, all the asset categories offer similar risk-adjusted returns, but clearly there are environments in which the Sharpe ratios are very different across asset classes. These environments can result from significant relative-value anomalies or inflection points in the economic cycle, for example. The point is, when they occur, the more lopsided the return opportunities, the less optimal strict balance becomes. The other important condition that undermines optimality is when we see negative Sharpe ratios across the majority of portfolio building blocks. If everything is going down together, leverage works against you. Q: Did your research reveal how changes in the bond market might affect a risk parity approach? Knight: A classic point of contention for risk parity is that interest rates, in general, are too low, and that while the approach may have performed well in the past, it is only because of an historic bond rally, which is unlikely to happen again. We were interested in applying some formality to the determination of a level of rates where this criticism becomes valid. That is where our research began. Q: How did the research and the resulting ideas translate into the strategy in place today? Knight: Our research operationalized those ideas with an intuitive classification methodology: we look at the bond market and stock market and assess whether conditions are normal or not normal. Ultimately in the bond market, the key was understanding when rates are, in fact, too low. We looked at more than 40 years of data and found that roughly 80% of historical observations showed business as usual in the bond market. But this meant that 20% of the time, the market was not normal. We observed the same pattern for the equity market. We found that the distinction of “normal” and “not normal” is important not only for the asset class that we are referencing, but also in a cross-asset test. When the bond market is unfavorable, it can tell you something about your equity and commodity outlook. When the equity market is favorable, it can tell you something about your bond and credit outlook. When we are in the neutral bond/neutral stock intersection, our risk allocation is balanced. In the periods where market conditions are not normal, the strategy adapts, deviating from a balanced risk allocation, and either adding or reducing risk exposure as appropriate in a hard-wired policy response. Q: What did your market state classification tell you heading into the election? Knight: I should stress that the indicators that we consider are based on long-established market dynamics, not topical situations. Entering November, our market state classification identified unfavorable bond market conditions and favorable equity market conditions. In this environment, which we call “highly bullish,” we tend to see negative returns from bonds and positive returns from equities and other cyclical assets. The hardwired portfolio response in this state is to de-emphasize interest rate exposure and to increase exposure to equity and inflation-sensitive investments. Q: And going into next year, what market conditions will make the adaptive approach valuable again? Knight: I believe the nature of the change that I discussed at the outset—the shift from a reliance on monetary policy to fiscal policy—will engender shifts in market states on a more regular basis. A growth agenda may be good for equities, but the untethering of the monetary policy experiment may not be good for equities, and there may be some ambiguity as to what this means for risk assets and portfolios. The post-election environment, we think, offers a higher-than-usual chance that the vulnerabilities of static risk parity become exposed, at least in the short run. I take comfort in the fact that we have a methodology that can address these conditions, shifting risk allocations based on the market environment. I am not suggesting that we can predict every wiggle and nuance of the markets. Rather, our strategy uses a classification methodology that only signals a change in risk allocation when key metrics move to an unusual and meaningful extreme. Q: For an investor that does not have a risk parity allocation, does that volatility argue for holding off on allocating? Knight: It is always very tricky to try to time an entry point into any long-term investment, but I think that the consequence of a mistimed investment would be less of a concern in an adaptive strategy than a static strategy. That said, if we observe a considerable setback in rates, that may create a more comfortable entry point into an investment strategy like ours.
Columbia Threadneedle Investments manages more than $470 billion in assets under management for individuals and institutions, as of September 30, 2016. They offer a broad suite of investment capabilities, with over 300 investment professionals and a long history of competitive performance. To learn more about Columbia Threadneedle Investments, please visit their website at columbiathreadneedle.com. The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Columbia Threadneedle associates or affiliates. Actual investments or investment decisions made by Columbia Threadneedle Investments and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate. Columbia Threadneedle Investments is the global brand name of the Columbia and Threadneedle group of companies.