Tuesday, October 27, 2015

AI-CIO risk parity survey says - The thrill is gone

The AI-CIO Magazine Risk Parity survey is out and it shows that the thrill has gone out of the risk parity strategy for a lot of investors. It is not going to disappear like some fashion fads, but the growth phase may be over and investors are giving this strategy a closer inspection.  Public pensions and endowments have cutback on its use and smaller investors seem to be less interested in employing the strategy. Only 19% of those surveyed are considering an increase in their allocation to risk parity over the next 12 months.

How risk parity is being used is also going through a sea change. It is being more thought of as a tactical allocation strategy or a cash overlay. Most investors are also thinking about risk parity as an absolute strategy and not as a substitute for a 60/40 stock bond allocation. Performance expectations have fallen with the declines in returns. The survey also seems to suggest that it is harder to even classify how this strategy should be benchmarked with 30% falling into the other category. 

The heart of the issue seems to be that 2/3rds of all users are moderately to extremely concerned about performance and over half are concerned with the use of leverage and counterparty risk. Targeting volatility and using leverage to achieve the target is a potential issue. These results are not surprising since risk parity products have not performed as well as simple stock bond allocations over the last 18 months. With the performance issues, there are concerns about education which tells me that many bought this strategy without full knowledge of how it would perform.

For non-users, the key issues seem to be the same, leverage, performance, and education. Clearly, there will be greater concerns about leverage given the current low volatility environment. Performance will be an issue when there are large discrepancies between return and volatility. Performance is critical during the transitioning in volatility states. Risk parity will leverage low volatility asset classes to get parity. If volatility increases, there can be a significant decline in performance if the transition is not handled properly.

Education concerns tell us that many are not clear on how to include this strategy within the context of an investor's broader portfolio. If you believe the risk parity story, why would you then make only a small allocation and leave the rest of the portfolio focused on traditional cap weightings?

A key risk parity problem is one of cognitive dissonance. If you like the story of risk parity, why would you structure the rest of your portfolio in a different way that is not based on risk parity? You cannot have it both ways. Additionally, it is also hard to determine what is the appropriate benchmark for performance. Is it an absolute number or a combination of stocks and bonds? There is no benchmark agreement and confusion on how to monitor this strategy.  

Risk parity may be here to stay, but it is not going to dominate allocation decisions. Parity chasing is over.

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