A couple of articles in InvestmentNews and The Wall Street Journal discuss the recent underperformance of risk parity funds. To recap what such funds do:

“Risk parity funds operate under the notion that the majority of risk in a portfolio comes from stocks. So instead of investing 60% of a portfolio in stocks, the funds lower the stock allocation and use leverage to boost the returns of the safer side of portfolio, e.g. bonds, to achieve the same returns with less risk.”

“Risk-parity funds use leverage to try to increase returns on bond investments so they more closely resemble returns of stocks. The basic idea of the strategy is that by equally distributing risks among stocks, bonds and commodities, the portfolio can weather huge price swings without sacrificing returns.”

The benchmark for these funds is typically a classic balanced portfolio of 60% stocks (e.g. represented by the S&P 500® index) and bonds (e.g. Barclays Capital Aggregate Bond Index). As indicated by a performance chart for one of the funds mentioned in the articles, AQR Risk Parity Fund (AQRIX), it is not easy to beat that benchmark even over a period of several years:

AQRIX Performance

Lately, risk-parity strategies underperformed:

“That is mostly because stocks have tumbled along with bonds after the Federal Reserve hinted at a reduction in its stimulus program last month. Making things worse, commodities and inflation-protected securities, which are widely used by risk-parity managers as a hedge against inflation, also suffered heavy losses because of receding inflationary expectations.”

To see why, let’s consider the long-term and short-term correlation coefficients between returns of stocks, bonds and commodities, represented by SPDR® S&P 500® ETF (SPY), iShares Core Total U.S. Bond Market ETF (AGG), and PowerShares DB Commodity Index Tracking Fund (DBC), and iShares TIPS Bond ETF (TIP):

Correlation 7 Years (Monthly) 1 Month (Daily)
SPY – AGG 0.09 0.63
SPY – DBC 0.60 0.66
AGG – DBC 0.04 0.48
SPY – TIP 0.21 0.45
AGG – TIP 0.75 0.89
DBC – TIP 0.38 0.32

The above figures clearly illustrate a significant increase in correlations between SPY and AGG, AGG and DBC, SPY and TIP, and AGG and TIP, in the last month. This explains losses suffered by risk parity strategies: stocks, bonds, and commodities all moved down in unison, and leverage exacerbated the bond downfall caused by rising interest rates. Thus, the basic premise of equalizing the risk contributed by uncorrelated components was broken, and risk parity turned to “risk disparity.”

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