April 12, 2021: Risk Parity Funds In Current Environment | Better Financial Future -- MyPlanIQ

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Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Monday May 3, 2021.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Risk Parity Funds In Current Environment

Risk parity approach was made famous by Bridgewater (and its founder Ray Dalio). The approach was dubbed as ‘all weather’ as it was intended to work all the time regardless of market conditions.

Unfortunately, the strategy took a hit last year. In this newsletter, we review some risk parity funds in the market and discuss the strategy going forward.

The risk parity strategy

The risk parity strategy in its original form is to allocate assets evenly based on their risk. In a simple fashion, the risk of an asset class such as stocks or US stocks is defined as their volatility. For example, let’s say US stocks, represented by VTI, has volatility of 17.7% (in the last 10 years, annualized standard deviation) and US bonds, represented by BND, has volatility of 4.3% in the last 10 years, a risk parity allocation for a portfolio of consisting of only US stocks and bonds would demand the stock/bond allocation ratio = 4.3/17.7. From this relationship, one can derive the US stock allocation =4.3/(17.7+4.3)=19.5% and the bond allocation = 80.5% or 1:4 ratio. In this way, both the stocks and bonds contribute about the same ‘risk’ or ‘volatility’ to the overall portfolio.

The above can be extended to more than two assets. In general, stocks and bonds are the two major assets that are extensively used in a risk parity portfolio. However, other assets such as gold and currencies can also be added.

Bridgewater’s all weather portfolio also include employing derivatives such as bond and/or stock futures to boost returns.

For example, Morningstar shows the allocations of AQR risk parity fund AQRIX on December 31, 2020:

And the major stock and bond holdings:

So, in this case, roughly, we can see that stocks/bonds ratio is about (35.59+14.89)/201 or about 1/4, not far off from our previous estimate.

The fund utilizes futures to achieve almost 2.5x leverage (in the unlevered portfolio, stocks would be about 20% and in the actual fund portfolio, it was 50%).

Recent performance

Unfortunately, the risk parity approach has encountered some unfriendly weather conditions in the recent years. The following table shows the risk parity funds MyPlanIQ tracks:

Risk Parity funds returns and risks (as of 4/9/2021):

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR	Maximum Drawdown
AQRIX (AQR Risk Parity I)	3.9%	19.0%	8.0%	8.6%	6.1%	17.7%
WFRPX (Wealthfront Risk Parity W)	-1.2%	7.7%	1.9%	-0.3%*		42.8%
PPROX (Putnam PanAgora Risk Parity Fund Class R)	-5.1%	7.2%	2.1%			20.5%
RPAR (RPAR Risk Parity ETF)	-3.3%	14.6%				19.8%
VBINX (Vanguard Balanced Index Inv)	4.9%	31.2%	13.5%	11.8%	9.9%	32%

*: Since 1/22/2018, Wealthfront risk parity fund inception date

**YTD: Year to Date

We make the following observations:

AQR fund actually delivered respectful returns in its history: its returns and maximum drawdown (from a peak to its subsequent trough) is only 17.7%, almost half of VBINX, a traditional 60% stocks/40% bonds balance index fund.
Unfortunately, other risk parity funds took big hit recently. Wealthfront fund has delivered a dismal return since its inception in 2018: -0.3% annually. It encountered a heart-wrenching drop in 2020: 43% maximum drawdown. This is certainly not acceptable for a fund that’s supposed to be balanced.
Other funds haven’t done well either: mediocre returns for both Putnam and RPAR funds.

To say the lest, these risk parity funds aren’t suited to all-weather conditions at all.

Double whammy going forward

Unfortunately, current market conditions present double whammy for the risk parity approach: the historically high stock valuation and ultra low (zero or negative) bond interest rates (thus most likely, bond prices will either stay at current levels or go down as prices are just inverse of bond interest rates).

For stocks, going forward, the likely returns for the next decade are not promising. Hussman estimated that S&P 500 annual return for the next 12 year will be close to -5%. He also estimated that a 60/30/10 (stocks/bonds/cash) portfolio will return -2.15% annually for the next 12 years. Other well known long term stock metrics such as Shiller’s CAPE-10 or Buffett Market Cap/GNP(GDP) ratio all indicate that stock valuation is at an extreme level.

Stocks can still go up in near terms as right now, strong monetary and fiscal policies are deployed to counter the Covid-19 pandemic. Furthermore, the new administration has also started a long awaited next generation infrastructure project that certainly will generate strong economic activities (with the likely expense of substantially incurring more debts). However, there is also an extremely high chance for future long term stock returns to be extremely low. This doesn’t bode well with a risk parity strategy that’s supposed to work under all different conditions,.

In fact, Bridgewater, the inventor of this approach, has started to tweak the strategy by moving away from bonds to other alternative investments such as gold and currencies. Unfortunately, the alternative assets are not as well understood and well managed as bonds. Nothing else, this will present more uncertainties to the strategy.

Of course, it’s also likely that bond yields will stay low and even go lower (to negative) in the coming years. So nothing is certain. That again presents another uncertainty.

All in all, risk parity strategy that has worked so well in the past, is facing some very different market conditions. This has shown up in the recent performance of its funds.

In our opinion, the current extreme market conditions demand a tactical strategy, as was mentioned many times in our newsletters before. For example, the following are from January 4, 2021: Our Investment Philosophy For 2021 And Beyond:

Finally, we are more and more confident that our improved tactical strategies (both Asset Allocation Composite (AAC) and Tactical Asset Allocation(TAA)) will be able to deliver better returns with lower risk than an SAA or buy and hold popular portfolio in the coming years. Our composite market indicator incorporates both macro economic indicators and market indicators to guide general risk asset allocation. The indicator is more relaxed than the risk asset allocation decision in our previous TAA strategy so that it’s not too sensitive or too quick to reduce risk asset exposure because of the relative strength in ‘safe’ bond asset. We believe such an indicator will cope well in the current environment while still managing to reduce big loss in a distressed environment.

Market Overview

For the past several quarters, we have seen that S&P 500 companies delivered better than (managed down) expected earnings. We are now officially entering Q1 2021 earnings report period. Based on Factset, for Q1 2021, the estimated earnings growth rate for the S&P 500 is 24.5%. If 24.5% is the actual growth rate for the quarter, it will mark the highest year-over-year earnings growth rate reported by the index since Q3 2018 (26.1%). As expectation is now universal for companies to deliver and beat the expected earnings, we are afraid that investors will need to be better prepared for negative surprises. Negative surprises in the current nose bleeding valuation level will not be friendly to stocks.

In the health front, as more and more people are vaccinated, it’s fast approaching to a juncture to see whether current vaccines can effectively control the virus, especially for the mutated ones. This might present another uncertainty for markets.

We reiterate the following practice:

For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation now reached another high. For the moment, we believe it’s prudent to be cautious while riding on market uptrend. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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