"Risk Parity and Rising Interest Rates"
Quick piece updating how various RP products are performing over the past two years and the rising interest rate environment. Some helpful commentary at the end wondering how RP if rising rates continue.
Read the original:
Nicolas Rabener
Important Points for the RP Investor:
How RP strategies might do in an era of sustained high interest rates has long been an open question. Since the early 1980s, interest rates have steadily moved downwards, producing a steady upward movement in bond prices. RP approaches have benefitted from this steady tailwind, essentially combining the best of both worlds of rising equity and bond prices. Commodities have generally not kept up, but their typically smaller allocations have meant that even basic RP strategies have had a good run of things.
Ahh, but what happens when the bond music stops? At that point, falling bond prices would become a strong headwind instead, rendering RP portfolios sluggish, and even in danger of stalling and crashing. We have had a brief look into that world over the past few months, as government bonds have declined in the face of rising interest rates installed to curb inflation. Predictably, this has been a challenge for RP portfolios, though in this case, commodities have been a buoying force, or at least until May or so.
This piece, written by Nicolas Rabener, CEO of FactorResearch, has two basic functions: one, to track how various RP indices and funds have done in this era of rising rates, and two, to investigate possible futures for RP as a strategy if such funds continue.
As for the first, Rabener runs two backtests. The first compares the 10-year Treasury yield with two RP indices: the S&P Risk Parity Index and the HFR Risk Parity Index since 2007, with the good ol’ 60/40 thrown in, as well. Take home point: the 10-year yield mostly declined, and the three indices all increased, from about 2007 until 2021, when both patterns reversed. Then Rabener compares the S&P Index with five RP funds on the market (WFRPX, ABRYX, PPRYX, AQRIX, and RPAR). Again, the take home point is generally strong performance, except for about the past 18-24 months.
Rabener closes with some sensible points - basically, “hey, if this continues, it’s probably not great for bond-heavy portfolios.” Rabener writes: “Looking forward, investors may be concerned about the strategy as there seems more downside from rising than upside from decreasing interest rates.”
Certainly, I don’t disagree, but my overriding thought reading this quick paper is that Rabener seems to have a different timeline than I.
As a long-term investor, the dip in bond prices represents a buying opportunity. Yes, bond prices are falling, but will they never rise again? This is just the chance to add more so they can carry the portfolio at another time, just as commodities did for the first five months of 2022.
Moreover, one of the previous complaints about fixed-income has long been that with such low interest rates, they have offered paltry dividends. Even if we have a pessimistic outlook for bond prices, then by definition, we would be pleased with bond yields. By definition, we have to have one or the other - though the real effects of inflation need to be considered, of course.
I don’t know what will happen, well, with anything really, but especially not the long-term future direction of interest rates. It seems like the perma-bears have predicted 5,149 of the past five bond crises, and yes, one of these days, I’m sure they will be correct, if only for a moment. Meanwhile, I just muddle through, trying to put in more money into the assets that are relatively cheaper than their counterparts, and withdrawing from them when their prices become relatively higher. This seems to work, at least for my purposes.
* Got this from a reader who thought it might be worth sharing (thank you FV!). If any other readers find a piece that might be good for the RP community, feel free to send it my way at riskparitychronicles@gmail.com.