Risk parity funds have failed to work as advertised

In times like these, when nothing seems to work in financial markets, risk parity strategies should act as a sort of shock absorber. It's a simple concept, really. Unless you have reason to believe one investment is better than another, you should take equal risk in each. That gives you maximum diversification, and diversification is still the only free lunch in finance.

Risk parity gained popularity in the 2008 crash, but interest gradually waned in the following years when the stock market went only up. Diversification has gotten cool again since the onset of the pandemic as a mitigant to an uncertain and volatile world. But these funds haven't always managed to work as advertised, leaving investors, especially the nonprofessionals, with unexpected losses.

While risk parity has been interpreted in a variety of ways, the practical definition for asset managers today is a fund that tries to take equal volatility in stocks, bonds and commodities, with a target overall volatility that is most commonly 10% per year. This is approximately the volatility of a conventional portfolio invested 60% in stocks and 40% in bonds. But because stocks are more volatile than bonds, 60/40 took 82% of its risk in stocks over the last 10 years; it got only limited diversification benefit from bonds, and none from commodities. In theory, and in empirical data going back many decades, risk parity should deliver consistently better returns with the same volatility as 60/40.

However, in the last 10 years, taking excessive risk in stocks has been a winning move. Stocks averaged 10.9% per year, bonds negative 0.9% and commodities negative 0.4%. As a result, the risk-parity index  has returned only 6.0% with 10.8% realized volatility, compared with 6.3% with 10.1% volatility for a 60/40 portfolio.

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But as AQR Capital Management Chief Investment Officer Cliff Asness (whom I spent a decade working for) points out, that's not the right way to look at it for most investors. If you were choosing between putting all your money in a risk parity fund versus 60% in stocks and 40% in bonds, you'd take the choice with the higher return and less volatility. But most investors think about adding risk parity to an existing portfolio.

Risk parity has "alpha" compared with 60/40, meaning a combination of risk parity and 60/40 does better than 60/40 alone. If you put 20% in risk parity and 80% in 60/40, you got a 6.3% annual return over the last 10 years, with 9.8% volatility — basically the same return as 60/40 with slightly less volatility.

While these are not inspiring statistics, recall that they were accomplished over the longest bull market in stocks in history, when both bonds and commodities lost money. Few investors have confidence that will characterize the next 10 years. Given that risk parity was only slightly worse than 60/40 on an absolute basis, and that it added some value when combined with 60/40, in the worst possible market for it, there's room to think it may be a good addition to stock/bond portfolios going forward.

Stocks are down 16.5% with 19.8% volatility over the last year, and bonds are down even more, 19.8% with 6.3% volatility. So, 60/40 got crushed, losing 17.5% with 13.5% volatility. In this disaster year, risk parity did not do well — two thirds of its risk was in assets with poor performance — but it was helped by a banner 22.9% return for commodities (albeit with a sky-high 20.2% volatility). The net result was a down year, minus 11.3% with 14.3% volatility, but a strong performance relative to 60/40. Over the last year, an 80% 60/40 portfolio with 20% risk parity added 1.2% to annual returns and cut volatility by 0.5% compared with pure 60/40.

Unfortunately, while risk parity works in theory and has a respectable track record over the last decade, risk parity funds available to the public have not lived up to theory. The table below shows statistics for some public funds over the last year (the UPAR Ultra Risk Parity ETF has only 36 weeks of data, and AQR rebranded its risk parity fund, though it still follows risk parity principles while having added some active management).

Why do most of the public funds lag the index so much? Two reasons. First, the S&P risk parity index ended up taking 5.0% volatility in stocks, 6.2% in commodities and 6.5% in bonds. Of course, it tries for equal volatility in all three asset classes, but it's impossible to predict future volatility perfectly. 

The second reason was performance relative to constant allocation. The S&P risk parity index beat a constant allocation to the three asset classes by 9.0%. This outperformance comes from changing the allocations over the year to maintain constant volatility, which added significantly to performance. Basically, volatility went up in asset classes before prices fell, and fell before prices rose.

This is not a year calculated to bring investors back to risk parity. Most of the risk parity funds on the market provided dismal returns and even the best fund and the index lost money. Quants will continue to sing the praises of diversification and alpha, but until retail risk parity managers can adhere closer to theory, and we get a period with actual positive performance, I think risk parity will remain an institutional strategy.