Risk Parity — Your Asset Selection Matters

When we talk about Risk Parity, the first thing that comes to our mind is literally the words RISK and PARITY. Or in simple English, EQUAL RISK. Risk Parity is just a generic term for a type of risk-based allocation. One where we allocate assets in our portfolio such that each of them holds an equal amount of risk. The premise of pursuing such an allocation approach is simple and elegant. If you can’t predict reliably which asset class will perform and which will not, then just make sure they drive the portfolio equally. I talked about this in an earlier post I wrote.

Risk Parity — There Is A Problem With The Name

However, the name by itself, gives no emphasis to another important part of the portfolio construction process. And that is selecting the right mix of assets. Without the right mix, Risk Parity can’t work its magic.

If you select only risky assets such as equities, high yields junk bonds in your pursuit for returns, nothing will save you at the time you need it.

If you pick every single asset out there, thinking diversifying as extensively as you can is the answer, you may find yourself owning too little of the assets that can make a difference during those few crucial periods. Markets are much more interconnected. In such instances, a simple equal risk allocation across all these asset classes might not do as well as intended because many of the asset classes which took up a slice of the risk gets correlated.

I do not know the exact mechanics of what other funds use. Each is different. But their average performance do suggest leaning towards the latter. It is not surprising. Because of their size, they are pushed to diversify everywhere in order to deploy their funds effectively.

Institutional Risk Parity Fund Performance

2020 COVID-19

Institutional Risk Parity funds went deep into the red in 2020. Their agonies started in February and worsened dramatically into March. At the end of March 2020, most are nursing double digit losses for the year. Many of these funds operate based on a target volatility controlled by adjusting leverage. The higher their target volatility, the more their leverage, the worse they are hit. Based on numbers compiled by HFR Risk Parity indices, these funds are on average down between -10% to -17% alone for March, and -13% to almost -20% for the year.

They are typically spread out across all major asset classes ranging from equities, credit, commodities, FX carry, real estate and sovereign bonds. It is not hard to see why they are down if we look at how the different classes performed during February and March 2020.

February looks bad. But the killer was March. With the exception of Gold and Treasuries, everything took a big hit. Stocks nosedived, credit collapsed, commodities crashed, FX carry unwound, REITs tumbled… Cracks appeared across all major markets including Treasuries which faced liquidity issues. It was a perfect storm. Mixed in a big dose of leverage, and you get a potent concoction called bloodbath. As prices fell and volatility surged, these funds delever, aggravating an already painful selloff.

2008 Lehman Collapse

If we want to draw a parallel, we can fall back to Sep 2008 — Nov 2008. Lehman filed for bankruptcy in Sep 2008 and sent markets into an extreme panic mode. How the markets moved in the months that followed looks like what we just went through, except that it was worse. In these 3 months, again every major asset except Gold and Treasuries, plummet.

What Happen To These Asset Classes During The Crisis?

Large cap, small cap, or whatever cap. They are all COMPANIES running businesses. So essentially they have the same “genetic makeup”. When the economy breaks apart, they crumble together. Corporate credits are debts of the same COMPANIES. The probability of defaulting on their obligations will rise, and that expectation is reflected with the prices of their issued bonds falling.

Energy elements such as crude oil is a large component in the Commodity basket. So the fallout between Saudi Arabia and Russia in cutting oil production earlier played a big part in the recent sell off. But that said, when economy sinks, business slows, demand plunge, commodity prices generally falls (with some exceptions like Gold which has low correlations across the different markets).

FX carry trade is a popular trade. For a long time, funds borrowed in low cost currencies to invest in higher yielding currencies to profit from the interest rate differential. It works well as long as the currencies remain fairly stable. For example borrowing in Yen or even USD, and then investing in AUD or other high yielding emerging market currencies. But when panic descends, investors pull their funds out and flock to the dollar in droves. The value of these high yielding currencies plunged beyond what the interests could cover. This forced carry trades to unwind, further exacerbating the sell offs.

The real estate market, similarly, suffers. Sales slow as Buyers and Sellers put their decision on hold. Rentals drop. Mortgage defaults rise. Prices head south.

The only assets that has a higher probability of survival in such times are the traditional safe havens such as Gold and Treasuries.

Assets Are Rallying Again

At the point of writing of this post in April 2020, almost all the asset classes are rallying. Investors piled back, funds relevered, shorts covered… If the trend persists, you can expect the Risk Parity funds to do well this month. But given that many would be operating below their typical leverage when the recovery starts, it would be some time before they recoup their losses.

The credit goes to the US Federal Reserve again for bailing everyone out. But they had a big hand in creating the mess today from the loose monetary policies they set during the GFC. And like it or not, you will need them to keep the music playing. The million dollar question is when the music ends? Perhaps when we see a major shift in the world order where US loses its power and influence, but no one really has the answer.

Select Your Assets Carefully

But coming back to asset selection, there is no need to represent every single thing in the market if it does not make sense. Unlike large established funds, for most individuals, we don’t have the issue of having too much money to invest (although I am sure we don’t mind having such problems). So we do have a choice. Do some due diligence, and select your mix of assets carefully.

Originally published at https://investmentcache.com on April 20, 2020.