Risk Parity strategies have been effective and popular
strategies since the early 1990s as diversification benefits
enabled risk parity strategies to make money in most environments.
However, the tide may be going out for risk parity strategies as
rising interest rate environments impact their ability to use
leverage to boost returns.
While investors wonder if this is the ebb of risk parity
strategies, the number of alternative mutual funds and ETF/ETNs
continues to rise. This raises the following question. If both risk
parity and alternative funds provide diversification and downside
protection, can allocation to alternative funds provide risk parity
like returns? In other words, are alternative funds the new risk
*Risk Parity portfolio consists of 8.8% MSCI USA Small Cap,
10.7% MSCI USA, 10.6% MSCI USA Value, 10.8% MSCI USA Growth, and
59.1% Fixed Income (CITI 10+ Govt Bond Index). Market Portfolio is
60% Equity MSCI USA IMI and 40% Fixed Income. Sharpe Ratios 85 -
2011. Source 2013 MSCI Barra
Historically, as shown by the MSCI Barra graph above, risk
parity strategies have weathered market downturns and delivered
returns above a standard 60% equity/40% bond market portfolio.
However, as interest rates have risen starting in 2Q2013, risk
parity strategies have been hit hard. The graph below shows two
risk parity strategies, one managed by AQR and the second managed
by Invesco. Both funds have taken significant hits since May 2013
with the funds down 6.45% and 3.21% YTD respectively
Bootstrap comparison: Risk Parity vs. Alternative+
The graph below shows growth of a $1 invested since March 2004
for a passive, non-levered risk parity portfolio as compared with a
60% equity/40% bond market portfolio. As expected, the risk-parity
portfolio lowers downside risk via diversification and maintains a
greater return until 2Q2013. The market portfolio closes the gap
and then overtakes the risk parity portfolio only due to the
extended bull market from 3Q2012 to 1Q2013.
*Risk Parity portfolio consists of 8.8% Ticker: VB, 10.7%
Ticker: SPY, 10.6% Ticker: IWD, 10.8% Ticker: IWF, and 59.1%
Ticker: AGG. Market Portfolio is 60% Ticker: SPY and 40% Ticker:
As the growth comparison is based on a passive, non-levered risk
parity strategy, a chart of AQR's Risk Parity strategy is also
included as AQR uses both leverage and active management. The
inception of this mutual fund is in 2010 so the chart is from
October 2010 until August 20, 2013. The reversal in May 2013
markedly stands out in this graph.
Investment in alternative funds that provide absolute and low
correlation to equity returns should also provide downside
protection and a risk/return structure similar to risk parity
strategies. Alternative funds and ETFs have become increasingly
popular as a method to provide hedge fund like returns without the
2/20 administrative costs of hedge funds. Many of these funds
started trading post-crisis and therefore don't have a long track
record. However, indices such as Hedge Fund Research's Global Hedge
Fund Index (HFRX) may provide a proxy measure for aggregate level
For purposes of this research, two alternative funds were
chosen. The first is the Natixis ASG Global Alternatives Fund
(Ticker: GAFYX). The second is Goldman Sachs Absolute Return
Tracker Fund (Ticker: GARTX). GAFYX is an absolute return fund that
seeks to provide capital appreciation consistent with a portfolio
of hedge funds. Similarly, GARTX also seeks to provide returns
consistent with investment in a basket of hedge funds. Both GAFYX
and GARTX began trading in 2008.
Two alternative portfolios were created. Alternative portfolio1
has a 40% allocation to Fixed Income (
), 40% allocation to equities (
), and 20% to the alternatives fund (
). Alternative portfolio2 has a 40% allocation to Fixed Income, 40%
allocation to equities, and 20% to the alternatives fund (
). A 20% allocation to alternatives came through reduction of the
60% equity allocation in the market portfolio. The basis of only
decreasing the equity allocation is that, historically, returns
from a basket of hedge funds have a higher correlation with
equities than bonds. Likewise, a basket of hedge funds also should
provide downside protection when applied to equity investments.
Interestingly, correlation of the AQR fund (
) to GARTX and GAFYX are much lower (0.22, 0.38) which points to
the effect of active management of a risk parity strategy. The
$1Growth charts shows how closely a passive risk parity and
alternative portfolio have moved together since 2010.
Does this prove that alternative+ portfolios are the new
risk parity strategies?
No. However, this does infer that alternative portfolios can
provide passive risk parity like returns. Alternative portfolios
should also provide downside protection as well.
In the last five years, a number of alternative ETFs have been
created. These ETFs include a variety of hedge-fund basket and
replication ETFs, including Index IQ's IQ Hedge Multi-Strategy
Tracker ETF (TICKER: [[QAI]]) and ProShares Hedge Replication ETF
(TICKER: [[HDG]]). In theory, allocation to these ETF hedge basket
tools will provide diversification and passive risk-parity like
returns. Absolute and Market Neutral Funds like Credit Suisse
Merger Arbi Liquid Index ETN (TICKER: [[CSMA]]) and State Street's
SPDR SSgA Multi-Asset Real Return ETF (TICKER: [[RLY]]) should also
be considered. These new classes of alternative ETNs and ETFs open
up the alternative across the retail investment space.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
Government Shutdown: Time To Sell?