"Can Risk Parity Outperform If Yields Rise?"
A common explanation for Risk Parity’s success over the past 40 years is that it has been heavy in bonds during decades of rising bond prices. In a different regime with falling bond prices, it is said, RP is destined to underperform. Hurst and others studied both periods of market history, and found that RP actually beat a standard 60/40 portfolio in periods with BOTH rising and falling bond prices.
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Important Points for the RP Investor:
Page 2: Whenever bond yields rise (meaning: bond prices fall), critics of risk parity are quick to rush out and claim “I told you so” as they watch a key component of RP portfolios decline. This paper “seeks to dispel a common misunderstanding about risk parity and focuses on examining how we believe the strategy may perform in a period of rising interest rates.”
Authors compare RP portfolio with the 60/40 over three periods: moderately rising rates from 1946 to 1979, sharply rising rates from 1979 until September 1981, and then falling rates from then to the paper’s publication in 2013. If the fear for RP portfolios is that they are a one-trick pony that only applies to periods of falling rates (read: rising prices), then their performance over the other two periods should be instructive.
Page 4: Exhibit 3 contains the findings: RP outperformed a US-based 60/40 and a Global 60/40 in both total annualized gross returns and Sharpe ratios for the moderately rising and falling rate periods. In the period of sharply rising rates, the two 60/40s both did badly, but RP did even worse. For these two years, cash was the place to be, and suggesting an economic regime that RP could struggle with in the future (along with pretty much every investment portfolio approach I’ve seen). The authors write that periods of rate shocks “can induce investors to de-risk their portfolios,” meaning a decline in all asset classes except for the safest asset, cash.
Pages 5-6: Authors suggest five possible economic scenarios to consider in terms of interest rates. Commentary on suitability of RP in each scenario. This section elaborates on the simpler model in some of the Bridgewater papers.
Page 6: Paper concludes with an evaluation of RP approaches based on the evidence. “We believe there is strong theoretical and empirical backing to suggest that more diversified portfolios, like risk parity portfolios, can produce superior risk-adjusted returns relative to concentrated portfolios.” They also note that at times, the edge for RP is slight, but over a long period of time, the slight advantages can compound into a substantial outperformance.
Other Resources Related to this Paper:
Interested readers You may want to read Chapter 13 of the Shahidi book along with this paper, as Shahidi tackles the same issue of when RP doesn’t seem to work very well. He also finds that periods of “risk-off”, when investors become adverse to any type of risk and seek safety in case, are tough times for RP (but also that a similar fate awaits a 60/40, and 80/20 or other common portfolios).