By Roger Nusbaum, AdvisorShares ETF Strategist
Last week, Bloomberg TV had an interesting segment on increasing correlations in the last few days as prices for equities, bonds and even gold all went down. It noted a sharp decline for risk parity as measured by the Salient Risk Parity Index.
Ray Dalio and Cliff Asness are probably the two most well-known managers who use the strategy or at least a version of it.
Risk parity weights exposure to the asset classes such that it attempts to balance out the risk of being in those asset classes. This means bonds have a much greater weighting than equities to the point of using tremendous leverage. According to the Salient website the index currently has 24% allocated to equities, 50% to commodities, 199% to sovereign debt and 123% to credit. Again, the strategy employs a great deal of leverage.
Year to date through Friday the Salient Risk Parity Index was up 15% even after rolling over somewhat last week (the point of the Bloomberg segment). Its return has gotten a boost from the bond market of course and so all of that bond exposure could be problematic if rates rise, depending on how Salient reassesses the risk when/if rates do actually rise. Every so often there will be headlines about risk parity managers getting caught wrong footed and getting pasted as a result.
I find this to be a fascinating concept in the same way I find Harry Browne’s permanent portfolio (25% each to stocks, gold, long bonds and cash) to be fascinating. While we’re at it we can also include the recent commercials from a fund provider trying to suggest that 60/40 should be replaced by 50% equities, 30% fixed income and 20% alternatives.
This leads into a conversation about risk adjusted returns as well as what I think of as being portfolio efficiency. My introduction to the concept came in 2001 when I was working at Fisher Investments. One of my colleagues like to talk about being able to get the same return as the S&P 500 by shorting the Nikkei with just 2% of your portfolio. Presumably this was from the peak in 1989 and while it doesn’t matter whether he was exactly correct or not it does speak to portfolio efficiency.
“Portfolio efficiency” has several applications. Mark Yusko from Morgan Creek likes to use levered ETFs for certain broad asset class exposure to potentially capture the full effect of the market with plenty of cash to be opportunistic. I would add that while waiting for that opportunity, if you’re actually matching the market with a whole bunch of cash set aside then you would be getting a strong risk adjusted result. There’s no guarantee of this with levered funds of course but that is the building block of understanding.
These sorts of alternative asset allocation ideas are on their face too extreme for my liking and so while I would not want to lever up a portfolio along the lines of risk parity I do like the idea of actively managing the portfolio’s volatility and believe in using alternatives (or as I started calling them many years ago; diversifiers) which is why I’ve written about them so frequently.
Gold is a good example. It tends to have a low to negative correlation to the equity market. If an investor is worried about equity volatility (maybe they think a bear market is coming) and they swap some equity exposure for gold they are adding something (gold) that tends to not look like the equity market and so might reduce correlation. The more they add the more of a reduction in correlation they might experience.
Merger arbitrage funds and certain hedge fund replicators can also fit in here as of course so would a fund that sell short one way or another (funds that sell short should have a negative correlation). Maybe a modest allocation to a fund that employs risk parity (they’re out there) would also work. Something like 130/30 is not something I would use in this regard. At 130% long, 30% short the fund would appear to be net long of equities (hat tip Dennis Gartman) 100%. The strategy can absolutely be successful over the long term but at net long 100% I would expect that to be an equity proxy and so if the context is wanting to look less like the equity market then adding something that is 100% long would seem to be contra indicated.
If an investor put half of his portfolio in these diversifiers they probably would look very little like the stock market. Occasionally that is the correct positioning but the stock market goes up the majority of the time so the majority of the time an investor should want his portfolio to look like the stock market (within the context of their target allocation).
With a nod to the fund company pitching 20% in alternatives, I think even that is too much. Increasing exposure to diversifiers up to 10-15% when equities show signs of rolling over (like when the broad market breaches its 200 day moving average) can go a long way to smoothing out the ride in a downturn which is what efficient asset allocation is all about. All the more so if some of that alternative exposure delivers on the expectation of negative correlation.
And if despite the market appearing to be in trouble, it isn’t, then 10-15% allows for much more participation in the upside and again, the market goes up far more often than it doesn’t. Anyone thinking that will no longer be the case would probably want to be out of equities altogether but that is not the thesis of this post.