Investment Insights

Jeff Benjamin

Risk-parity funds: A delicate balancing act

By Jeff Benjamin

Sep 2, 2012 @ 12:01 am (Updated 9:27 am) EST

Considering the Invesco Balanced-Risk Allocation Fund's (ABRIX) impressive three-year run, one might naturally assume that the entire fund industry would be ramping up to mimic the risk-parity strategy it employs.

The Invesco fund, which invests based on projected risks, as opposed to returns, has grown to more than $8 billion since its 2009 launch and has earned a five-star rating from Morningstar Inc.

One of the most interesting points about mutual funds' employing risk-parity strategies is that there isn't much competition.

Morningstar analyst Samuel Lee counts just four funds using this strategy, which in many respects turns traditional asset allocation on its head by managing a portfolio for a specific risk or volatility target.

The strategy can be tweaked in a number of ways, but the basic concept involves building a portfolio that spreads risk evenly between stocks, bonds and commodities to create an annualized volatility target roughly in line with a traditional portfolio of 60% stocks and 40% bonds.

The aim is to avoid the lopsided risk of a traditional 60/40 portfolio, in which 90% of the volatility comes from the equity exposure.

FINANCIAL ENGINEERING

Creating a portfolio of balanced risk across three asset classes requires some financial engineering, and that's where some investors, as well as some money managers, might not feel comfortable.

In the Invesco fund, for example, the risk is balanced by using derivatives and leverage to create a portfolio made up of 90% bonds, 30% equities and 30% commodities.

The leverage, which is applied through the use of exchange-traded- futures contracts, is necessary in managing volatility while generating performance, said Scott Wolle, chief investment officer of Invesco Ltd.'s global asset allocation group.

“The idea is to provide a smoother ride for investors,” he said. “The bonds provide the hedge against things like recessions and crises, but a 40% allocation to bonds is not enough protection when things go south.”

There is no denying that the heavy risk exposure from a 60/40 portfolio will outperform a risk-parity model during a period of strong stock market rallies, such as the late 1990s.

But volatility cuts both ways, and over the long term a smoother ride will leave investors with less ground to make up after downturns.

Salient Partners, a $17 billion asset management firm that launched the Salient Risk Parity Fund (SRPFX) in July, has compared the volatility and returns of risk-parity strategies with traditional portfolios dating back to 1990.

In the 21-year period through 2011, a 60/40 model had a 6% annualized return, a 10% standard deviation and a maximum peak-to-trough decline of 37%.

Over the same period, the Salient risk-parity model generated a 16.5% annualized return. It had a slightly higher standard deviation of 12% but trimmed the maximum peak-to-trough decline to 16.1%.

“A risk-parity strategy is a risk-management device, so it's targeted to not spike or trough as much,” said Salient CIO Lee Partridge.

Salient, which manages $5 billion in institutional risk-parity accounts, spreads the risk across four broad categories: global equities, sovereign bonds, commodities and a strategy that will invest the fund's underlying positions long or short.

Salient's fund has balanced risk with 55% in bonds, 25% in commodities and 20% in stocks, for a managed-volatility target of about 4.5%.

It uses leverage through futures contracts to increase the volatility to about 12% and keep returns in line with the world allocation category.

The other risk-parity mutual funds are the $776 million AQR Risk Parity Fund (AQRNX) from AQR Capital Management LLC and the $126 million Managers AMG FQ Global Essentials Fund (MMAFX), which is subadvised by First Quadrant LP.

Of the three risk-parity funds that have been around more than a year, the AQR fund is up 9.4% from January, the Invesco fund is up 8.5% and the Managers AMG fund is up 5%.

The risk-parity strategy is benchmarked to the Morningstar moderate-target-risk category, which has an average gain of 8.7% from the start of this year.

The AQR fund gained 5.1% last year, while the Invesco fund gained 10.5% and the Managers AMG fund climbed 7.9%; the target risk category average was 0.6%.

Based on the steady flow of money out of equity funds and into bond funds, it appears that investors are ready for a strategy that concentrates on risk, which is why these kinds of funds should continue to attract assets.

The real test for risk-parity funds, however, will be keeping investors on board during the next bull market cycle in stocks — when risk tolerance usually spikes and caution becomes boring.

Questions, observations, stock tips? E-mail Jeff Benjamin at jbenjamin@investmentnews.com Twitter: @jeff_benjamin