Risk Parity & Rising Rates

Risky Risk Parity?

May 2022. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Risk parity strategies have become available via mutual funds and ETFs, but portfolio construction varies
  • Rising interest rates are seen as a threat and recent performance was disappointing 
  • However, rising correlations between stocks and bonds would be more concerning

INTRODUCTION

Risk parity has been challenged ever since the world’s central banks have brought interest rates to approximately zero via quantitative easing programs post the global financial crisis in 2009.

The strategy aims to allocate the same risk to different asset classes, which results in bonds getting the largest allocation due to these being less volatile than stocks. Given that bonds have been in a bull market since the 1980s, having overweighted fixed income, often with leverage, has been a winning bet. It also created fortunes for early proponents of the strategy, like Ray Dalio at Bridgewater Associates. 

Asset managers that offer risk parity products like to highlight that rising interest rates are not all bad for bond allocations as it does imply higher yields. After all, the long-term return of a bond is related to its starting yield. Naturally, this argumentation ignores any losses on bonds that are sold before maturity (read ETFs for Rising Interest Rates). 

As inflation has reared its ugly head across nations, central bankers have started raising interest rates, which represents a new market environment for the majority of investors. In this research note, we will evaluate the recent performance of risk parity indices and products as interest rates have increased from record lows.

RISK PARITY INDICES & INTEREST RATES

We use two risk parity indices namely the HFR Risk Parity Index and S&P Risk Parity Index as benchmarks in this analysis. The former consists of single fund managers pursuing the strategy, while the latter is simply an index calculated by S&P. Both target a volatility of 10% per annum on the index level, which is achieved via scaling the exposure to asset classes up and down. If required, leverage is used.

We observe that both indices featured the same trends over the last dec