Risk Parity in an Era of Low Interest Rates
Since 2008 Erik Knutzen has been leading Investment Strategy and Asset Allocation recommendations for NEPC’s clients. Over the past few years they have been developing a Risk Parity approach for asset allocations. We asked Mr. Knutzen about their process and how it translates to
the overall investment strategies for institutional investors.
Thank you for carving out some time for us Erik. Please highlight for us what you believe to be the key advantages of a risk parity approach over traditional applications of modern portfolio theory.
At NEPC, we have for some time been recommending that investors consider a risk balanced approach to asset allocation, which can sometimes be called seeking “Risk Parity”. We have summarized our views on this topic in white papers which we make available on our website including “Risk Parity: In the Spotlight After 50 Years” by my partner Chris Levell, and most recently, “Risk Parity – What Were We Thinking?” by my partner Tim McCusker, which considers this strategy in the current environment. My comments here will reflect the more fully developed writings of my colleagues.
We believe that Risk Parity is an asset allocation concept that is not biased to a particular interest rate environment, stock market direction, or inflation episode. Our view is that the core advantages which have allowed Risk Parity to perform well remain in place. We can boil down the investment thesis and its advantageous role in a portfolio into three broad differentiators relative to traditional approaches:
Diversification – Risk Parity recalibrates most asset allocations away from their largest risk driver: equities.
Efficiency – As a standalone approach, Risk Parity presents an improved risk-return profile relative to a traditional asset allocation.
Resiliency – With balance across risk exposures, Risk Parity is not dependent on a single asset class to perform well. In particular, the approach is less reliant on equities and economic growth than a traditional portfolio comprised of 60% stocks and 40% bonds.
Would you advocate investors applying risk parity principles to their entire portfolios or adding separate risk parity funds to their broader portfolios? Why?
We recommend Risk Parity as a strategic component of diversified asset allocations or the starting point for structuring a total portfolio. We believe that risk parity can be applied at the total portfolio level or as a discrete strategy within an investment program. We have worked with a few institutional investors to apply Risk Parity at the total program level.
While the results have been good for these approaches, there are implementation challenges that must be overcome including building and managing a derivatives overlay program to gain exposures at the total program level, applying the exposure and risk management tools necessary to manage the program’s risk budget and liquidity, and perhaps most importantly, educating the Committee and/or Board. For most investment programs incorporating a stand-alone risk parity allocation in their manager line-up can add valuable diversification and help improve the overall program return and risk profile.
Please tell us a little bit about expected return characteristics in different interest rate environments.
There has been a great deal of focus on the expected performance of Risk Parity strategies in a rapidly rising interest rate environment. We believe that the strategy’s performance in a potential rising rate environment should be evaluated based on overall diversification benefits, not simply the large notional exposure to bonds. However, when focusing on expectations for bonds within the Risk Parity portfolio, it is critical to evaluate the impact of rising interest rates relative to what is already priced by the market. An examination of forward yield curves indicates the market is already pricing in a rising rate environment. To the extent rates do rise, the new level must be higher than what is already priced in before having a negative impact on bond prices.
Conversely, if rates rise less than forecasted by the market, bonds actually perform better than expected. We may not be in a rising rate environment today, but the market certainly says we will be. That possibility is already priced into markets, therefore, the impact on returns is actually more limited than one would expect. Importantly, rising interest rates and disappointing fixed income returns are by no means a foregone conclusion in the near term. A continued, long-term, global deleveraging places downward pressure on interest rates.
While the future is unknown, the evidence has built towards a continued deleveraging instead of a broad and sustained recovery. Looking at the interest rate path of Japan over the last twenty-plus years, it is clear that this environment could persist for more than a decade. If rates remain low or fall further, and equity markets move sideways due to sluggish growth, Risk Parity is likely to outperform traditional allocations dependent on strong equity returns.
So, what if interest rates do move higher than what the market already expects? We can paint a few different pictures of environments that would lead to rising rates and consider how Risk Parity might perform in each of those.
Strong Global Growth – In this environment, growth-sensitive assets like equities, commodities and credit would likely provide strong performance. While Risk Parity would likely underperform 60/40 in this scenario, absolute performance would likely still be strong as Risk Parity benefits from the positive performance of equities and commodities to offset losses from nominal and inflation-linked bonds.
Rising Inflation – This environment is likely challenging for stocks and bonds. Risk Parity’s exposure to inflation-linked bonds and commodities would be beneficial. While rates are rising, leading to negative results for nominal bonds, it is also likely a challenging environment for equities. The balance and diversification of Risk Parity, particularly its exposure to inflation-sensitive assets (generally under-represented in traditional allocations) likely allows it to outperform traditional allocations in this environment.
Surprise Rate Hike – This event would likely be concurrent with a combination of strong global growth and rising inflation. An unexpected increase in short-term interest rates presents headwinds for all asset classes. A surprise rate hike essentially positions cash as more a challenge for all portfolios, not just Risk Parity. Risk Parity may experience negative returns if interest rates rise, however, as markets adjust, Risk Parity will be positioned to participate in higher future performance over subsequent periods.
Risk parity funds have clearly seen tremendous in- flows over the last few years, do you expect this trend to continue, and what would you say to a board that is currently considering adding a risk parity strategy?
We do expect investors to continue to consider risk parity approaches to long-term investment programs, and we anticipate that there will still be some movement of assets into risk parity strategies. In our experience, however, the current low absolute levels of interest rates are discouraging some investors from considering a risk parity approach. Others are waiting for rates to rise before implementing.
In our view, Risk Parity should be viewed as a core approach to asset allocation. The strategy seeks to capture diversified risk premia and deliver stable, consistent returns across market environments.
Early adopters of Risk Parity were attracted to its diversification qualities, its overall efficiency of delivering a high expected return with moderate and balanced volatility, and its ability to perform resiliently across various market environments. As we look forward, we believe that the key tenets of the investment thesis for Risk Parity remain largely intact.