Found an interesting paper from AQR about Risk Parity performance.
- Critics argue risk parity is destined to perform poorly in rising rate environment, and thus conclude that the strategy is currently unattractive since interest rates are still at low levels and will eventually rise.
- Interesting part is when highlight October 1979 (a couple of months after Paul Volcker was appointed Fed chair) to September 1981, yields on 10 year treasuries quickly rose an additional 640 basis points to annualized yield of 15.8%. During this short period, all portfolios significantly under-performed cash, with risk parity portfolio suffering the most.
- Determine speed matters in determining risk parity performance in increasing interest rate environment
- To be good bond investor, not only does one have to predict right direction of interest rates, but also right speed and magnitude of the yield moves – a difficult task according to AQR. The reason for this is because bond prices reflect the market’s expectation of the future path of interest rates. Investors usually expect rates to rise which leads to an upward sloping yield curve (yields further out in the future being set higher than short term yields).
- Upward sloping yield curves enable bond investors to earn both the coupon and the ‘roll down’ return if the term structure remains similar, giving bond investors a cushion against the possibility of rising yields.
- If yields do not rise as expected, bond investors typically enjoy high risk adjusted returns.
- If bond yields rise as expected, bond investors have still historically earned a risk premium (to perhaps compensate for the risk that yields could have risen more).
- This explains why, over this long period where rates rose quite substantially, bond investors were still able to enjoy positive returns more than cash.
- Give 5 scenarios to consider
- Rates could fall further.
- Rates could stay at similar levels as now.
- Rates could rise due to higher growth expectations
- Rates could rise due to increases in inflation expectations.
- Rates could rise due to a global sovereign credit crisis or because central banks lose control of monetary policy
- If think rates rise fast, risk parity might struggle vs 60/40
- If think equities crash, risk parity would outperform