There have been a lot of naysayers about the old-fashioned 60/40 portfolio, but this year is proving that it is hard to improve on a classic.
The $19.5 billion Vanguard Balanced Index Fund (VBINX) which maintains a boring 60% allocation to the total U.S. stock market and a 40% allocation to the Barclays U.S. Aggregate Bond Index, and re-balances regularly, was up 5.48% this year through June 24, while risk parity, a popular alternative, is underwater.
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.
The focus on managing risk has struck a chord with investors.
Risk parity mutual funds, which have about $30 billion combined in assets, had $16 billion of inflows in the past year, according to a recent USA Today report.
The problem is, today's less-risky assets aren't nearly as docile as they have been in the past.
Now that the Federal Reserve has signaled that it is ready to take its foot off the stimulus pedal, the interest rates that it has kept at historic lows have sprung to life.
Since May 1, the interest rate of the 10-year Treasury has shot up nearly 100 basis points, to about 2.5%.
That has ripped a hole in the bond market and subsequently through the leveraged portions of the risk parity funds. Meanwhile, it has wiped out the S&P 500's 11% year-to-date return and left investors in the red.
The $13.9 billion Invesco Balanced-Risk Allocation Fund (ABRZX) is down 4.98%, the $1.2 billion AQR Risk Parity Fund (AQRIX) is down 6.7%, and the $246 million Putnam Dynamic Risk Allocation Fund (PDREX) is down 5.64%.
“Risk parity is long the risks of the world. When the risks of the world do badly, it will do badly,” said Michael Mendelson, principal at AQR Capital Management LLC.
“In the last quarter, most of the risks of the world have done poorly,” he said. “It happens infrequently, but it does happen.”
The important thing for advisers to remember is that risk parity should be considered a strategic investment, Mr. Mendelson said.
“Strategic investment will have good times and bad times,” he said. “The last couple months have been bad times but they'll have good times again.”
“Real rates have effectively been repriced. That means a better outlook for all long-only strategies,” Mr. Mendelson said.
But Scott Wolle, chief investment officer of global asset allocation at Invesco Ltd., isn't ready to concede victory to the 60/40 portfolio.
“Just because you don't outperform in every single period doesn't mean it's a bad idea,” he said. “Occasionally things aren't going to work in your favor, but by keeping discipline, you keep the odds in your favor over time.”