How effective is the risk ratio

Is the game of «risk parity» going wrong again?

In the past, low interest rates have boosted the prices of almost all assets - the opposite may be threatened in the future. For some, the LTCM disaster serves as a wink with the fence post.

The wealth management industry tends to promise its potential clients a blue sky. Sophisticated investment strategies should generate above-average returns with calculable risks even under the most difficult conditions, as marketing likes to boast about. Statistical studies and experience show that this is not always that easy in the long run.

Price losses on bonds

The problem of the topic becomes clear in a message in which the well-known and for decades extremely successful hedge fund manager Ray Dalio informed the clients of his company Bridgewater Associates at the end of June about the management of his $ 80 billion "All Weather Fund »to have underestimated the interest rate risk of certain asset classes. The fund is inspired by the basic idea of ​​using a clever, risk-oriented combination of various forms of investment to achieve robust returns in all “life situations” without having to make predictions about the future. That is why shares are in the custody accounts of many pension funds.

However, this plan did not work in the short term after Ben Bernanke, the President of the US Federal Reserve, surprised the markets in the spring with the announcement that he was considering gradually ending the very expansionary monetary policy strategy. This announcement alone had led to notable price losses in the bond markets - especially in inflation-linked bonds.

The "All Weather Fund" also suffered a decline of 8.4% in the second quarter of the current year after Dalio had reacted to the changed environment by the end of June and sold interest-rate-sensitive securities worth $ 37 billion, such as the Bloomberg news agency reported. In previous years, the fund had posted gains averaging just over 9%.

Surprises of this kind are only a foretaste of the difficult times that may yet come, says securities strategist Ramin Nakisa from UBS. He asks what will happen as soon as the central banks actually take their foot off the “monetary policy accelerator” when the markets have reacted as sensitively as in the past few weeks to a slight hint.

Rising interest rates could in future become problematic for those funds that have done well in the past by dividing their investors' money between equity and bond investments, taking into account a precisely defined risk-return target. Quantitative “risk-parity” approaches of this kind have worked well in the past few decades, but the success is mainly due to the predominant trend towards lower interest rates in this phase. All those portfolios that contained a relatively small portion of volatile equity securities and a large portion of partly debt-financed bonds would have benefited from this. For a long time, they were able to benefit from coupon income and rising prices on the bond markets at the same time.

However, this combination could become a problem as soon as rapid and significant increases in interest rates on bonds lead, at least temporarily, to corresponding price losses on the bond markets, explains Nakisa. Recalculations based on historical data would have shown that “risk parity portfolios” in the late 1970s to early 1980s would have suffered temporary losses in value of up to 22% when interest rates rose rapidly.

It would therefore be particularly spicy today if fund managers had acquired on a larger scale securities with low liquidity that react sensitively to changes in the interest rate landscape. You don't have to go back long to assess the possible consequences, says Nakisa. After all, the hedge fund LTCM failed in 1998 and had to be rescued with the help of the American central bank after speculating with enormous loan-financed bets on reducing yield differences and burning the equity, which was already deliberately scarce, within a very short time.

Doubts about models

Investment strategist Ben Inker of Grantham, Mayo, Van Otterloo writes that the temporary simultaneous price losses of almost all assets after the “Bernanke hint” in May and June challenged the correlation-based risk models of many asset managers. Most of them are designed to cope with growth and inflation shocks, but not with "valuation risks". After the promises of the central banks to remain expansive in monetary policy for the time being and to keep interest rates very low, initially boosted the prices of all assets to such an extent that investors could hardly have done anything wrong, the opposite may be the case in the future.

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