August 22, 2014 5:55 pm

Risk parity and McNuggets: a history

Rising interest rates risk to survivial of risk parity approach
McDonald's China Co. Chicken McNuggets are displayed for a photograph in Beijing, China, on Tuesday, July 6, 2010. McDonald's China Co. said its McNuggets contain two "harmless" additives that comply with Chinese food standards. The additives are tertiary butylhydroquinone and dimethylpolysiloxane, which are not found in the U.K.-made version. Photographer: Nelson Ching/Bloomberg©Bloomberg

It may not be as obvious as the link between mankind and Neanderthals that scientists have been discussing this week, but the fashionable theory of portfolio design known as “risk parity” shares a common ancestor with the McDonald’s McNugget. (The common ancestor is homo ponteaquam, of whom more below.)

The McNugget grew and thrived and, with a few exceptions like Moscow , dominates the globe. Risk parity, on the other hand, after several years of strong institutional and retail investor inflows to the strategy, may struggle to expand further. It is the subject of a scientific debate about whether it can survive in a new environment, and Janet Yellen’s Jackson Hole speech will only serve to turn up the heat in that debate.

Risk parity has been touted as an alternative to a traditional portfolio of 60 per cent equities and 40 per cent bonds, whose exposure to equity market volatility meant a sickening plunge during the financial crisis. A risk parity portfolio is meant to equalise exposure to different kinds of volatility, so no one asset class can tank the portfolio.

In practice that means bringing in commodities and substantially increasing exposure to the more placid bond market, which has generally done well when commodities and equities are fading. But sceptics say investors who have piled into risk parity are effectively making a giant leveraged bet on fixed income at the peak of a three-decade bull market in bonds. And the sceptics have new research on their side.

First some theory, courtesy of homo ponteaquam, commonly known as Ray Dalio, founder of the hedge fund giant Bridgewater.

McDonald’s almost didn’t introduce the McNugget back in 1983, for fear it would be hostage to fluctuating prices for chickens, for which there was no futures market where they could hedge the risk. Mr Dalio’s young fund came up with the idea of helping chicken farmers hedge feed prices such as corn and soymeal, so they could sign a contract to supply chickens at fixed prices.

The fast food world got the McNugget, and Mr Dalio got to ponder on this investment insight, that any return stream can be sliced into its component risks and analysed accordingly. “If assets can be broken down into different component parts and then summed up to a whole, so too could a portfolio,” Bridgewater wrote in an article on the history of its All Weather fund last year. Backtests show risk parity portfolios, with their leveraged exposure to fixed income, outperforming traditional 60/40 portfolios over many time periods, with less of that stomach-churning (and retirement-delaying) volatility.

Salient Risk Parity index

A new study by Emanuel Derman and Mengyao Lu for KKR Prisma, the hedge fund where Mr Derman is co-head of risk management, suggests that risk parity portfolios face a one-two punch from rising interest rates. Most of the pain comes from the rising cost of borrowing needed to leverage up the portfolio, according to the research, but atypically sharp rises in interest rates and falls in bond prices, such as we saw during last year’s “taper tantrum”, could ding returns, too.

The conclusion, which is based on running 1,000 different scenarios for commodities, equity markets and bond yields over the next 10 years, is that a typical risk parity portfolio is only going to outperform a 60/40 strategy if interest rates remain low and commodity returns are high, reversing their recent funk. What would have to be happening in the real world for that to be the case? Perhaps the return of inflation and central banks ignoring it. It is a possible scenario in the short run, but not a probable one over the long haul, and it might even be getting less likely in the short run. As Ms Yellen shifts her views on labour market slack, the odds rise that interest rates will go up sooner than later, and potentially quite quickly.

Risk parity is doing well this year, thanks to the renewed downward lurch in long-term bond yields.

The long view suggests challenges ahead. The taper tantrum was a taster. Funds such as those run by Invesco and AQR, had an annus horribilis in 2013, prompting some investors to flee. Bridgewater’s All Weather fund was itself down 4.6 per cent, according to Morningstar’s hedge fund database. An era of rising rates means a rising likelihood of a repeat performance.

The funds that did best last year were those that had greatest room to make tactical shifts like cutting bond exposures, but such moves undercut the claim of risk parity to be a passive, quantitative strategy that can be delivered cheaply to investors. It is every bit as interesting as the debate over the Neanderthals. Will risk parity thrive or die out, or evolve into something else? Will it become as ubiquitous as the chicken McNugget, or will it be of interest only to future generations of investment paleontologists? The risks to risk parity are mounting.

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