Just over a year ago, in one simple graphic, we showed why Bridgewater, which currently manages around $150 billion, is the world’s biggest hedge fund. Quite simply, its flagship $80 billion Pure Alpha strategy had generated a 16% annualized return since inception in 1991, with a modest 11% standard deviation – returns that even Bernie Madoff would be proud of.
And, true to form, according to various media reports, Pure Alpha’s winning ways continued in 2013, when it generated a 5.25% return: certainly underperfoming the market but a respectable return nonetheless.
However, Pure Alpha’s smaller cousin, the $70 billion All Weather “beta” fund was a different matter in the past year. The fund, which touts itself as “the foundation of the “Risk Parity” movement“, showed that in a centrally-planned market, even the best asset managers are hardly equipped to deal with what has largely become an irrational market, and ended the year down -3.9%.
Ironically, we voiced our skepticism about All Weather last January long before the market’s Taper Tantrum and subsequent actual Taper, when we provided our opinion on (what was then and probably still is) the “world’s biggest and most successful “beta” hedge fund.” We said:
[W]hile we absolutely agree with Dalio that “there is a way of looking at things that overly complicates things in a desire to be overly precise and easily lose sight of the important basic ingredients that are making those things up” (they need those Econ PhDs for something), we certainly don’t agree with Bob Prince’s assessment that the entire world is merely a “machine” which can be understood, in terms of its cause-effect linkages.
While this may be true in simple two actor environments, and in theoretical, textbook markets, it is certainly not the case in a enviornment filled with irrational actors, who respond in times of crises – so vritually all market inflection points – with their feelings, instincts, phobias and gut reactions, than with anything resembling logic and reason. And especially not in times of “New Normal” central planning.
What happened next is well-known to most.
The NYT describes it succinctly: “A number of risk-parity funds like All Weather were caught off guard by a sudden rise in Treasury yields last summer. Treasury yields began to rise last May after speculation began that the Federal Reserve would soon scale back its monthly purchases of United States Treasury’s and mortgage-backed securities. The Fed began slowly scaling back its purchases, which are intended to stoke economic growth, last month. Last year also was a particularly rough one for TIPS and other inflation-protected securities. TIPS tend to perform poorly when Treasury yields rise and inflation is low. Last year, iShares TIPS, an exchange traded fund that tracks the inflation-protected securities market, fell about 9 percent.”
Long story short, the internal assumptions behind Risk Parity blew up spectacularly in a year in which yield soared, while equity markets dipped initially only to rebound furiously, without a concurrent spife in inflation expectations. Welcome to the New Normal.
To be sure, we narrated the implosion in Risk Parity in almost real time. Recall from When Will “Risk Parity” Blow Up Again:
In March we suggested that in a rising rate environment risk parity was susceptible to draw-down as yields gap higher. As it turned out this happened even sooner than we expected after the Federal Reserve’s June 19th FOMC statement. Despite the fact that the statement said nothing new, markets interpreted it as hawkish and Treasuries took a pounding. In the next two weeks ten year Treasuries lost over 4% in total return, creating an overall loss of 7.5% since the beginning of May. The situation was worsened by the fact that equities also fell briefly, but unlike Treasuries also rebounded quickly.
The consequence for some risk parity funds was a significant loss. For example the AQR Risk Parity Fund lost 13% from May 9th to June 24th and fared worse than shares, credit or Treasuries in response to the FOMC sell-off. The question is whether this will happen again, or was this event a one-off? We believe that this is a relatively mild foretaste of what is to come. Consider that this was a response to a hint that the Fed could start to taper its asset purchases which occurred while the Fed was moving its balance sheet far beyond historical limits at a rate of over $1 trillion per year. The responses to the actual onset of tapering and rate hikes are likely to be more severe. Our US economists believe tapering will begin in Q4 this year and end in Q2 next year but that rate hikes will be delayed.
But nobody was more critical of Risk Parity than GMO’s James Montier who in a December note equated the Risk Parity concept with “Snake oil in new bottles.”
Below are the salient points from Montier:
As I have written many times before, leverage is far from costless from an investor’s point of view. Leverage can never turn a bad investment into a good one, but it can turn a good investment into a bad one by transforming the temporary impairment of capital (price volatility) into the permanent impairment of capital by forcing you to sell at just the wrong time. Effectively, the most dangerous feature of leverage is that it introduces path dependency into your portfolio.
Ben Graham used to talk about two different approaches to investing: the way of pricing and the way of timing. “By pricing we mean the endeavour to buy stocks when they are quoted below their fair value and to sell them when they rise above such value… By timing we mean the endeavour to anticipate the action of the stock market…to sell…when the course is downward.”
Of course, when following a long-only approach with a long time horizon you have to worry only about the way of pricing. That is to say, if you buy a cheap asset and it gets cheaper, assuming you have spare capital you can always buy more, and if you don’t have more capital you can simply hold the asset. However, when you start using leverage you have to worry about the way of pricing and the way of timing. You are forced to say something about the path returns will take over time, i.e., can you survive a long/short portfolio that goes against you?
Exhibits 10 and 11 highlight this problem. Exhibit 10 shows the value/growth expected return spread over time. I’ve marked three points with red stars. Let’s imagine you had all of this time series history in the run-up to the late 1990’s tech bubble. Given history and assuming you were patient enough to wait for value to get one standard deviation cheap relative to growth, you would have put this position on in September 1998. If you had been even more patient and waited for a 2 standard deviation event, you would have started the position in January 1999. If you had displayed the patience of Job, and waited for the never before seen 3 standard deviation event, you would have entered the position in November 1999.
Exhibit 11 reveals the drawdowns you would have experienced from each of those points in time. Pretty much any one of these would likely have been career ending. They nicely highlight the need to say something about the “way of timing” when engaged in long/short space.
As usual, Keynes was right when he noted “An investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money.”
Risk Parity = Wrong Measure of Risk + Leverage + Price Indifference = Bad Idea
At a fundamental level, risk parity is the antithesis of everything that we at GMO hold dear. We have written about the inherent risks of risk parity before, however I think they can be stated simply as the following:
I. Wrong measure of risk
Many proponents of risk parity use volatility as their measure of risk. As I have argued what seems like countless times over the years, risk is not a number. Putting volatility at the heart of your investment approach seems very odd to me as, for example, it would have had you increasing exposure in 2007 as volatility was low, and decreasing exposure in 2009 as volatility was high – the exact opposite of the valuation-driven approach. As Keynes stated, “It is largely the fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”
I’ve already discussed leverage in the previous section, enough said I think.
III. Lack of robustness
There are no general results for risk parity. That is to say that adding breadth doesn’t necessarily improve returns. The returns achieved in risk parity backtests are very sensitive to the exact specification of the assets used (i.e., J.P. Morgan Bond Indices vs. Barclays Aggregates). Furthermore, decisions on which assets to include often appear fairly arbitrary (i.e., why include commodities, which, as Ben Inker has argued, may well not have a risk premia associated with them). All in all, the general lack of robustness raises the distinct spectre of data mining, and hence fragility.
IV. Valuation indifference
Proponents of risk parity often say one of the benefits of their approach is to be indifferent to expected returns, as if this was something to be proud of. I’ve heard them argue that “risk parity is what you should do if you know nothing about expected returns.” From our perspective, nothing could be more irresponsible for an investor to say he knows nothing about expected returns. This is akin to meeting a neurosurgeon who confesses he knows nothing about the way the brain works. Actually, I’m wrong. There is something more irresponsible than not paying attention to expected returns, and that is not paying attention to expected returns and using leverage!
As it turns out, Montier was right, and all it took was for one word out of Bernanke mouth to launch an market avalance which showed just how fallible the supposedly infailable can also be when trading a “market” that now is anything but.