A headline recently caught my eye: “Why Risk Parity Investors Have Lost Faith.” I haven’t certainly, but, with my interest piqued, I wondered about the reasons. Well actually, it turns out it’s just one pension manager in Europe, but still: why oh why are people jumping off the RP ship?
As mentioned before, I’m always on the lookout for criticisms, dissents, and the flaws of Risk Parity. While it clearly RP makes sense to me, I never want to reach a point where I just have a knee-jerk defense of it and ignore contradictory evidence or dissenting perspectives. I am always on the lookout for occasions where investors decide RP is not, or is no longer, the approach for them. Why do people turn away from RP? Where does it come up short? What can we learn from these cases?
So it was with great interest that I came across an interview of a pension manager in Denmark declaring that he has “lost faith in risk parity.” Kasper Lorenzen, CIO for $94 billion pension provider PFA, had been following a RP approach for years but turned away from it in 2021.
Sarah Rundell
The crux of Lorenzen’s decision is his view that, these days, bonds are in decline. With equities heading lower as well, the two asset classes “increasingly correlate and risk parity flounders when liquidity is being drawn out of the market and stagflation is creeping in.” Regarding the future decline of bond prices, Lorenzen has no doubt: “Don’t fight the Fed. You had to be bullish interest rates in order to be a risk parity investor.” Now, he says, times have changed.
Instead of risk parity as an operating framework, Lorenzen has switched to what he calls a “more balanced, risk-on, risk-off approach.” That includes shorting bonds when appropriate and pursuing targeted equity allocations that can prosper in times of stagflation, though this piece is not really specific about what he means on this.
If it sounds a bit like market timing and actively adjusting the portfolio to keep up with perceived shifts of economic regimes, that’s because it is. Whether or not Lorenzen will be proven correct or not I can’t say, but indeed, this paradigm shift does represent a step away from RP. One of the key tenets for RP (i.m.o.) is to have a diverse portfolio suitable for a variety of conditions in the same way a decathlete is poised to succeed in a variety of Olympic events instead of trying to guess at what the event might be. Lorenzen clearly favors the latter.
Elsewhere in the article, though, Lorenzen also declares that he hasn’t completely abandoned the RP approach and still believes that “stable, illiquid investments with a bit of everything are a good investment.” It is a bit odd, then, that for Lorenzen, risk parity seems to mean only stocks and bonds, with no mention of commodities, managed futures, gold, or other assets that might provide returns in a stagflationary environment (with the exception of real estate, which is mentioned).
This would seem to be another case where people take RP to just mean a combination of stocks and bonds, with more bonds to balance the risk between the two. Given that understanding, and if you’re confident in your ability to pick the future of an asset class, it makes sense that you would decrease your bonds as they are about to head south. But that’s not what I mean by RP, so if Lorenzen is moving away from it, he’s moving away from something else.
Anyway, this might just be a case of mistaken identity, and I’m not sure what Lorenzen’s shift in thinking means for my portfolio. It does suggest, though, that if equities and bonds continue to decline together, it may prove difficult for the average RP to maintain course. Even with an allocation to commodities, managed futures, gold, or whatever, stocks and bonds will likely constitute the majority of a portfolio and a decline for these two could swamp any uptick from alternatives. To me, the lesson there is that RP seems to be working, not that you should abandon RP and try to predict the market, but hey, what do I know?
By the way, here is another interview with Lorenzen that goes over many of the same points, in case you’re interested:
Wouter Klijn