The rise and fall (?) of Risk Parity is a great case study of the frameworks I have been writing about so far. We start with the concept of “Chasing Diversifiers.”
Chasing Diversifiers (link)
Although Risk Parity is as close as you get to a pure risk diversification play, just like other diversifiers, the benefits of Risk Parity were sold and bought when both the forward looking consensus about expected returns lined up with attractive recent returns.
2010: For Risk Parity’s product makers (as opposed to asset owners), that golden year when “the past aligned with the future” is 2010:
Risk Parity crushes the 60/40 by outperforming it by +13% in 2010! And many versions also outperform during the 2008 meltdown. Recent Returns: Check.
Worries mount about massive upcoming inflation due to unprecedented quantitative easing. Everyone agrees that expected return of a 60/40 is becoming too low and that another ‘2008’ is happening sometime soon. Future Consensus: Check.
To make things even more perfect, the performance during the following two years is stellar with Risk Parity beating 60/40 by +8.7% and +6.2% in 2011 and 2012. Excitement: Check
The Result: “Suddenly” all the logical diversification-based arguments for Risk Parity finally make sense to everyone and the Money Flows In.
2012: the adoption of Risk Parity is a huge hit.
Pension plans create a new category for Risk Parity in their performance reports which almost never happens. Bridgewater and AQR become the ‘go-to’ providers. Huge number of whitepapers (here and here) get produced, creating real fans with a cult-like following. Even the most famous self-help guru a few years later promotes Risk Parity as the smartest way to invest (here).
I wish I could end the blog here with a happy ending - “investors remain happy there after, committed to their Risk Parity allocations for decades to come” (or whatever the investment horizons they had in mind when making the allocations). Instead, the story turns painfully familiar.
2013: Just as pension plans feel warm and fuzzy having just implemented their Risk Parity allocations, 2013 rolls around with a staggering -19.4% under-performance vs the 60/40.
Ouch! 2013 was the year you dream of as an equity investor and Risk Parity totally sidesteps the gains, in fact even loosing -2% in total return.
2014-2015: Building on top of that, Risk Parity continues to under-perform the 60/40 during the next two years by -1.5% in 2014 and -9.9% in 2015.
The painful feelings grow into bearish arguments: talk of deflation spreads, allocations to commodities get questioned, Risk Parity’s equal Sharpe ratio assumption gets criticized, some label Risk Parity as a levered bond that is short volatility etc.
Anecdotally, during this period, I was sitting on quarterly investment committee meetings at one of the nation’s largest plans. Like clockwork, reviewing the performance reports, first one board member starts to raise concerns about Risk Parity, which gain support of other members with accelerating alarm as the under-performing quarters compound. It becomes very hard to turn-around with any logical reasons a sentiment that is gaining negative momentum.
Confidence in Risk Parity gets seriously weakened. Defense (here) and criticisms (here, here) mount - the views are predictably related to whether the firm offers Risk Parity products or competes against them.
2016-2017: Relative performance bounces back slightly (+5.4% in 2016 and 1.6% in 2017), buying some time and patience, but not enough to reverse the 2013-2015 accumulated pain, measured in double units vs the pleasure of the gains (thanks Kahneman).
2018: Another big punch. Risk Parity under-performs 60/40 by -7.3%.
2019: If you sold Risk-Parity in 2018, then 2019 continues your ‘timing torture’ because the large drop in long-term interest rates has propelled Risk Parity to out-performance once again.
* HFRI 12 Vol Institutional - https://www.hedgefundresearch.com/indices/hfr-risk-parity-vol-12-institutional-index
Takeaways
‘Chasing Diversifiers’ has not been a pleasant experience for Risk Parity investors. Since 2006, Risk Parity only slightly underperformed a 60/40 by -0.53% per year. I doubt that most Risk Parity investors had a similar result as the overall history. Do not make diversification decisions based on expected returns.
A fresh out of school analyst a few years from now will look at the performance table and not see any of the excitement or pain in these numbers. He will see averages, volatility and maybe tracking-errors. The years that feel so long in real time to the financial advisors and investment committees living through these decisions, will feel like milli-seconds in comparison. The ‘Chasing Diversifiers’ problem will be invisible to the analyst. He will run the numbers, write up an investment proposal, arrive at some new conclusions backed with the latest arguments and present them to the committee. Many of those ‘new arguments’ will reflect the latest combination of the recent returns and future consensus opinions. But that bias will remain obfuscated to the analyst until he lives through the long years that for now still appear as only small rectangular cells in a spreadsheet. Do not mistake an excel spreadsheet with real time investing.