If nothing else, market conditions over the past few years have proved that most investors tend to overestimate their true risk tolerance wildly.
Although it is easy to claim a high risk tolerance when the market is soaring to new heights, the market correction in 2008 jarred a lot of investors and financial advisers back to the reality that risk cuts both ways.
This renewed emphasis on risk bodes well for risk parity, a balanced investment strategy that aims for a less volatile ride by spreading risk evenly across a portfolio of stocks, bonds and commodities.
The basic concept — used first by institutions and now by at least three mutual funds — employs leverage to adjust the risk levels of underlying investments to create an optimally risk-balanced investment.
As a result of leverage, the current allocation of the $900 million Invesco Balanced-Risk Allocation Fund Ticker:(ABRZX), for example, is 35% equities, 100% bonds (with leverage) and 32% commodities. In terms of risk exposure, however, 40% comes from equities, 23% from bonds and 37% from commodities.
In a traditional balanced portfolio — a 60/40 stock/bond mix — 90% of total risk comes from the stock allocation.
Such concentrated risk isn't a problem during non-inflationary growth market cycles such as the mid-1980s and the late 1990s. But as many investors recently discovered, a 60% allocation to stocks can crush a portfolio in a down cycle.
“The different asset classes represent different economic outcomes, so it makes sense to have a lot of protection against each outcome,” said Scott Wolle, who manages the fund at Invesco Ltd.
For investors, hedging market risk translates into less upside potential during raging bull markets but far less downside when the market heads south.
“By avoiding big downturns, investors should be able to catch up more quickly,” Mr. Wolle said. “Also, if investors don't experience the extreme level of [downside] pain, they will be less likely to sell in a panic.”
The case for risk parity boils down to the idea that each of the underlying investment categories is likely to do better than others in a particular phase of the main market cycles: commodities during periods of inflationary growth, equities during times of non-inflationary growth and bonds during recessions and deflationary periods.
The Invesco fund, launched in May 2009, is by far the largest mutual fund applying the risk parity strategy.
In October 2009, the $100 million Managers AMG FQ Global Essentials Fund Ticker:(MMAFX) was converted to a risk parity strategy under subadviser First Quadrant LP, a $19 billion asset management shop.
And in October 2010, AQR Capital Management LLC launched the $80 million AQR Risk Parity Fund Ticker:(AQRNX).
Each of the three mutual funds is slightly different, but they share the objective of keeping the risk of the underlying assets in relative balance and overall standard deviation comparable to the 9% range of a standard 60/40 balanced portfolio.
The downfall of most traditional balanced strategies is that they rely on asset allocation to drive risk. In a risk parity strategy, risk exposure is managed in relation to market volatility.
The Managers AMG fund, for example, is currently 40% exposed to stocks and 120% exposed to bonds, with another 20% allocated to commodities and Treasury inflation-protected securities as an inflation hedge.
First Quadrant partner and portfolio manager Edgar Peters explained that the portfolio weightings are adjusted as market volatility rises and falls.
A period of low equity market volatility is considered favorable for stocks, and the equity portion could go as high as 50%, while bonds could drop to 100%.
When equity volatility is high, the stock portion could drop to 30% and the bond portion could be as high as 125%.
With expense ratios of between 97 basis points and 1.2%, the three funds are comparable to the world allocation category average of 1.2%, according to Morningstar Inc.
In terms of risk parity's fit in an overall investment strategy, the category's brief performance history suggests that it serves either as a core allocation or an equity alternative.
“Over the years, there have been lots of clever strategies, but I definitely think this could have potential, and it can be a core allocation,” said Morningstar analyst Russel Kinnel.
Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].
