Risk-Parity Strategies at a Crossroads, or, Who's Afraid of Rising Yields?
10 Pages Posted: 4 Jun 2014
Date Written: June 3, 2014
Risk-parity strategies have gained considerable popularity in recent years. For commonly accepted rumours have it that the historically attractive performance of risk-parity strategies has been due in large part to the trend toward record-low market interest rates. However, the yield situation looks set to return to normal in the medium term. This therefore raises the question of whether risk-parity strategies can continue to deliver a stable performance in the future in the face of potentially rising market interest rates.
By means of an empirical analysis that takes the USA as an example, this article demonstrates that a simple risk-parity strategy can pay off in an environment of rising market interest rates and stands up well against classical capitalisation-weighted portfolios, even when the high-yield phase of the 1970s is factored in. When the increase in market interest rates proceeds in an orderly manner, the risk-parity strategy achieves the best risk/return profile. This added value is attributable to two reasons. First, the high dynamism of the risk-parity strategy better exploits the diversifying characteristics of the different asset classes. Second, thanks to the target risk, the overall portfolio exposure continually adapts to the current risk climate and thus reacts procyclically to opportunities.
Despite this favourable finding, it is shown that although the risk-parity strategy is the one that profits the most from bonds when yields fall, at the same time it is the one that suffers the most from losses on bonds when yields rise. The risk-parity strategy’s attractive risk/return profile is therefore primarily attributable to the fact that stocks and especially commodities were able to offset the bond-loss phases. This serves as a clear reminder that risk-parity strategies exhibit more-than-negligible sensitivity to bonds. This can become problematic particularly in the event of interest-rate shocks like the ones in 1994 or 2013, when the correlations between individual asset classes suddenly spike and thus curtail the diversification potential within the portfolio.
Keywords: Asset Allocation, Portfolio Construction, Risk Parity, Managed Futures, Hedge Funds
JEL Classification: G1, G10, G11, G15
Suggested Citation: Suggested Citation