Risk parity mutual funds that had gained appeal for their sophisticated means of spreading risk evenly across a portfolio are suddenly on the defensive after the recent rise in interest rates exposed a potential weakness in the strategy.
The half dozen mutual funds employing the strategy, which often leverages bond exposure to reduce the risk from stocks and commodities, averaged an 8% decline during the second quarter when the yield on the 10-year Treasury bond jumped by 34%.
This year through the end of last month, the $14.7 billion in risk parity funds had an average decline of 3%.
That compares with a 4% gain for the world allocation fund category as tracked by Morningstar Inc. and a 20% gain by the S&P 500 during the same period.
The niche risk parity space, which had more than $8 billion worth of net inflows in 2012 and more than $2 billion over the first half this year, has ramped up its education campaign to remind investors what the strategy is all about.
“Two-thirds of the risk in our portfolio is in places other than bonds,” said Scott Wolle, chief investment officer of Invesco Ltd.'s global asset allocation group.
At $13 billion, the Invesco Balanced-Risk Allocation Fund (ABRZX) represents the bulk of the risk party fund space.
Although all such funds are unique, the Invesco model represents a relatively simple example of how the strategy works.
With the objective of avoiding the lopsided risk of a traditional 60/40 stock/bond portfolio, portfolio managers apply leverage to load up on lower-volatility assets such as bonds in order to create a portfolio where risk is spread evenly across asset classes.
In the case of the Invesco fund, this means a 75% allocation to bonds, 30% in stocks and 30% in commodities.
Mr. Wolle, who takes issue with some descriptions of these funds as “levered bond strategies,” explains that despite the large bond allocation, the portfolio risk is equally divided among asset classes.
“From our perspective, a third of the risk comes from bonds, and we'd say that's about appropriate, as opposed to most of the risk coming from stocks,” he said. “If bond yields rise, we have a good chance of offsetting that from gains in the other asset classes.”
Risk parity proponents such as Mr. Wolle aren't oblivious to the reality that rates are at historic lows and a rising-rate environment will drive down the value of most bonds, but he doesn't think that risk parity strategies are overly exposed to rising rates.
An Invesco study of the past nine periods of rising rates, dating back to 1950, shows that risk parity strategies would have produced positive annualized returns in every instance.
Further, the simulated analysis shows that the strategy would have outperformed a traditional 60/40 portfolio during seven out of the nine periods.
The rising-rate fears are further dampened in a research report by Salient Partners LP that looks at the cumulative performance of risk parity compared with that of a 60/40 portfolio during the rising-rate period from 1970 through 1981.
During the 11-year period that saw the yield on the 10-year Treasury go to 15.3%, from 6.2%, the risk parity model would have had a cumulative return of 235%, while the 60/40 model portfolio would have gained 118%.
“The point is, it doesn't matter if interest rates rise if they do so in an orderly manner,” said Lee Partridge, Salient's chief investment officer.
In the most basic sense, the risk parity strategy is designed to avoid too much correlation inside a portfolio in an effort to avoid everything from moving in the same direction.
“If we see higher correlations between stocks and bonds as rates rise, we end up putting fewer bonds in the portfolio, because the bonds are no longer acting as a diversifier,” Mr. Partridge said. “What people sometimes miss about risk parity is that the allocations are not static.”
Although it is true that risk parity strategy allocations aren't static, they might have a tendency to be tardy, as witnessed during the second quarter when the mutual funds in the category were caught flat-footed by a sudden rise in rates.
“Sudden interest rate moves will hurt risk parity strategies if those sudden rate moves are preceded by periods of low-volatility environments,” said Samuel Lee, a Morningstar analyst.
In essence, because risk parity strategies typically base future allocations on multiyear volatility patterns, a spike in rates can be punishing. But then, a sudden spike in rates can be punishing to most asset classes.
“Most risk parity strategies use some kind of volatility-forecasting model to determine weights for each asset class, but low volatility can sometimes trick these strategies into thinking future volatility will stay fairly muted,” Mr. Lee said. “During the second quarter, rates moved up rapidly sort of out of the blue, but in most cases, if rates are rising, it's because the economy is getting stronger, and that's going to be good thing for some asset classes.”