2008 was a year for the history books in the economics world. Not since the 70’s had we seen such a sharp drop in equities in such a short amount of time. Losses were not contained to the equities sector, or even this country in fact. Europe saw substantial losses as well, and the real estate industry is still recovering, slowly but surely. Highly leveraged investors and risky derivatives were the source of this market catastrophe, so surely we as investors would be smart enough to avoid them in the future…
Flash forward to 2013, hedge funds and money managers are at it again, this time in the bond market. According to the Wall Street Journal, more and more managers are engaging in the “Risk Parity Strategy.” The “Traditional Portfolio” as described by most finance professors consists of 60% stocks and 40% bonds, but when looking at the risk of the entire portfolio, the 60% stock portion carries 90% of the risk of the whole portfolio. This investment style aims to spread the risk around to various instruments, such as commodities or futures.
A marketable strategy, but a dangerous one as well. The article notes that in Fairfax, VA the Fairfax County Employees’ Retirement System has a 90% exposure to bonds when calculating in their leverage. As we have mentioned in several of our articles, the bond market is an incredibly dangerous play at this point in time. Bond prices and interest rates vary inversely, so if interest rates are low, bond prices are high, and vice versa. With rates at historic lows, bond prices can really only go one way.
Many investors will read that and say “no problem, when it turns down I will sell it off and be done with it.” That is just the type of dangerous thinking that will leave many market participants flat broke. Who exactly would you sell to theoretically? Realize that if long term federal debt goes from 3% to 6% interest, the value of the bond has been slashed in half; who would possibly want to buy in that type of environment? Furthermore, when prices fall, they do not decline gradually, they plummet quickly.
Many Risk-Parity proprietors have been singing a different tune when it comes to marketing their strategy. “We’re not as leveraged as Wall Street was back in 2008,” “We have ample liquidity” are both commonly heard defensive positions for those selling the strategy. It is all smoke and mirrors.
The fact is that Risk-Parity has only been around commercially since 2001 and has not truly stood the test of time. In that time, bond prices have done nothing but go up, and the theory has yet to prove that it can achieve substantial gains when interest rates begin to rise.
Another one of the fundamentals of this theory is that when stock prices fall, bond prices rise and the investor wins. The Dow Jones recently surpassed a 5 year high; does that sound like a good sign for bond exposure? Ray Dalio, president of Bridgewater Associates, says that if bond prices go down that equity gains should offset losses in Risk Parity portfolios. Let’s assume that same scenario of 3% interest rates rising to 6% and your portfolio is half debt exposure, half equities exposure; by Mr. Dalio’s theory, the Dow Jones would have to rise to well over 27,000 in order to counteract bond losses. Quite a far-fetched proposition to say the least. Mr. Dalio’s assertions sound very much like those of managers who used the Modern Portfolio Theory of the 80’s, which resulted in substantial losses for investors in the crash of 1987.
Mr. Dalio has also said, “Ironically, by increasing your risk in the bonds you are going to lower your risk in your overall portfolio.” That may be a fair way of thinking, in a falling interest rate environment. Simply put, the strategy cannot achieve substantial gains when rates begin to rise.
We urge all readers to use common sense, and do not be sold on highly leveraged and risky investment strategies. If it sounds too good to be true, it is. If someone tells you that their strategy is immune to losses, run like hell.