June 2012

CORRELATION: Levelling the see-saw

Sea-sawA portfolio spread across a dozen asset classes can still be vulnerable in a crisis. Risk parity managers say the secret is to strike a balance, finds George Mitton. Everyone knows you should spread your risk by investing in several asset classes. But what happens when these all underperform at the same time? This was the dispiriting experience of countless investors in the 2008 financial crisis and again during periods of last year. Diverse portfolios that included everything from equities to high-yield bonds, to real estate and private equity, suffered when these asset classes became correlated. Even gold, supposedly the safest store of value, fell about 20% between July 2008 and the end of the year, giving the lie to the claim it is a guaranteed hedge against equity risk. Investors learned a tough lesson in these times: correlation can increase in periods of stress. Asset classes that in normal times behave fairly independently can move in unison, to the detriment of investors. This phenomenon has continued throughout the past year thanks to the continuance of the “risk-on, risk-off” trade, which has kept correlations high. These experiences have prompted a rethink in the way investors look at diversification. Managers of risk parity funds, which aim to achieve an equal balancing of risk to protect against market trauma, believe they have a solution. Exposure
“People assume that adding in lots of asset classes will make you more diversified, but quite often these asset classes bring an overlap of the risks you already have in your portfolio,” explains Dan Greene, investment director of UK institutional business at Invesco Perpetual, which runs a successful risk parity fund. Risk parity funds are essentially balanced funds that attempt to achieve a more accurate spread between the equity part of the portfolio and the bond part. The oft-repeated claim is that, for a typical balanced fund that has 60% equity and 40% bonds, as much as 95% of the fund’s volatility is caused by equities. To achieve a better balance, risk parity funds use leverage to increase their exposure to bonds. They might take on a bond exposure worth 125% of their capital, against 45% in equities, for example. This more accurately balances the risk weighting between the two parts. Risk parity managers may invest in other asset classes, too. Some funds have exposure to commodities. However, these managers place commodities in the equity part of the portfolio because they regard them as having similar risk characteristics to equities. On the bond side, some funds buy interest rate futures, which have similar features to government bonds. The key is to see the two parts of the portfolio as counterweights. “If asset classes have a positive correlation in normal times, then in a crisis, these correlations go to one,” says Harold Heuschmidt, manager of risk parity funds at Aquila Capital.
“However, the opposite happens if you have asset classes that have a negative correlation. These correlations then go to minus one.” Risk parity managers say that, if the balance between the two counterweights is right, the fund will survive a 2008-type scenario unscathed. Any losses caused by falls in the price of equities, will be matched by gains on the bond side of the portfolio. “It’s too strong to call it a general economic principle, but the flight-to-quality idea is well entrenched,” says Heuschmidt. “If you get a selloff in equities, the money goes somewhere. Where does it go? To low-risk assets.” In a way, the lesson these funds hope to teach is that it doesn’t matter how an asset class is structured or sold; if it behaves like an equity it must be treated as one. According to this view, diversification is not a matter of filling your portfolio with different asset classes, it’s more about setting up two piles of assets on a see-saw and getting it level. This kind of strategy explains why, for some portfolios, an increase in market correlation need not be disastrous, and may even be beneficial. “Correlation can be good,” says Melissa Brown, senior director at Axioma, which provides technology for monitoring market movements. “It isn’t always good. It depends on how you do your stock selection and your portfolio construction. But it’s not the death knell.” But although there has been enthusiasm for risk parity funds in the past few years, there are also reasons to be cautious. Unsafe techniques
“The leverage and derivative use is a big governance burden,” says Matt Roberts, senior investment consultant at Towers Watson. “These are things many investors would not have considered before.” The problem, says Roberts, is not necessarily that these techniques are unsafe, but that they would be unfamiliar to many potential investors in such a fund. In order to do their due diligence, these investors would have to understand the techniques and the risks involved, which include counterparty risk. These investors might be small to medium-sized pension funds, rather than large ones that would be able to invest directly in the asset classes. Because of their small size, they might not have the resources to come to a quick assessment, he warns. However, these problems are not limited to risk parity. Diversified growth funds, which often aim for the same goal of minimising drawdowns in bear markets, also often use derivatives. Plus, with a diversified growth fund there may be further problems if the manager uses sub-funds, which cannot be easily scrutinised. “The transparency of [risk parity] portfolios is far greater than a comparable diversified growth fund,” says Greene. “Derivative markets are very liquid. You know exactly what you’re buying and you can trade in and out easily within a day. In many diversified growth funds there are sub-funds and it’s very hard to get a look-through to the underlying investments.” Greene also claims that the kind of leverage used by risk parity funds is not as hazardous as simply borrowing cash. In Invesco Perpetual’s case, the fund uses capital as margin in derivatives deals to gain exposure to bonds. Though the outcome is the same as borrowing money to buy bonds, the risks are different, he says. “You’re not subject to the same lending requirements which stimulated the fear of leverage in the 2008-09 period.” Intelligent thinking
Another criticism of risk parity is that these funds would perform poorly in an equity bull market and would soon fall out of favour. It is probably fair to say the focus on risk is a symptom of troubled economic times. But there may be more life in the risk parity model than the critics think. Many of these funds have an active overlay, meaning they can shift their asset allocations in response to market movements. The fund could increase its equity exposure to participate in a rally, for instance. Ultimately, what these funds offer is an intelligent way to think about risk, and there will always be demand for that. ©2012 funds europe

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