All Weather Portfolio
alternatives, analysis, asset allocation, hedge fund, portfolio

Today’s post on Yahoo Finance discusses an “all weather” portfolio recommended by one of the most famous hedge fund managers. The portfolio strives to achieve an equal distribution of risk across macro periods of inflation, deflation, high and low economic growth.

The portfolio consists of:

  • 30% stocks
  • 15% intermediate-term government bonds
  • 40% long-term bonds
  • 7.5% gold
  • 7.5% commodities

The portfolio has a large fixed-income component relative to equities to get close to a risk parity (yet, it does not use bond derivatives). The portfolio should be rebalanced at least annually.

Let’s use the Portfolio Service of the Alpholio™ App for Android to analyze this all weather portfolio. To do so, let’s construct a portfolio of ETFs that represent the above asset classes:

These ETFs were selected to have the earliest possible inception dates and lowest sponsor fees (expense ratios). The time span of the analysis is limited by the inception date of DBC. An alternative commodity ETF, the iShares S&P GSCI Commodity-Indexed Trust (GSG), became available about five months after DBC, therefore the latter was chosen. Since about 8% of DBC tracks gold, the weight of IAU is lower than that of DBC by one percentage point (due to the limitation of setting widgets, the app only accepts whole percentage weights).

Here is the setup for the analysis (the Dates, Return Frequency and Rebalance Frequency sections can be expanded by tapping their respective headers):

All Weather Portfolio - Setup

Here are the analysis results for the above portfolio with monthly returns and quarterly rebalancing:

All Weather Portfolio - Quarterly Rebalancing

With semi-annual (i.e. every six months) rebalancing, the all weather portfolio performed slightly better in terms of the higher annualized return and Sharpe ratio as well as smaller maximum drawdown:

All Weather Portfolio - Semi-Annual Rebalancing

Annual rebalancing yielded no further improvement in the annualized return or Sharpe ratio, but reduced the maximum drawdown to 12.1% and lowered the beta to 0.20.

For reference, here are the results for a traditional balanced portfolio, comprised of 60% SPY and 40% of iShares Core U.S. Aggregate Bond ETF (AGG), with monthly returns and semi-annual rebalancing in the same analysis period:

Balanced Portfolio - Semi-Annual Rebalancing

Compared to the traditional balanced portfolio, the all weather portfolio had all the desirable characteristics: a higher annualized return and Sharpe ratio, coupled with a significantly lower beta and maximum drawdown. However, the above analysis covered a prolonged period of decreasing and historically low interest rates that drove the returns of intermediate- and long-term bonds, the dominant positions in the portfolio. In an environment of rising interest rates (generally expected to begin next year) and falling commodity prices (already taking place), a risk-parity oriented portfolio, even with no bond leverage, may suffer.

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Risk Disparity
correlation, risk parity

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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