Hedge Fund Strategies: Is Ray Dalio’s “Risk Parity” a thing of the past?
The last 3 months have been a tumultuous time for hedge funds. With major, well-known players looking to capitalize from an increase in market volatility, hedge funds have never been more looked at to provide desperately needed capital gains using the market expertise they are notoriously judged and lavished by. However, what is mainly observed after 2 months of trading activity, is the simple consequence of differing strategies yielding different results. If we dig deeper, some old strategies thought of as the bedrocks of the industry shockingly underperformed, while more innovative and unorthodox rivals thrived. Is this simply a temporary hiccup or is the industry speeding towards a holistic paradigm shift in the near future?
For starters, particular hedge funds offer several different trading tactics. As such, it is not indicative to judge a whole fund’s performance, but rather the performance of specific portfolios implementing advertised, and well-tracked investment strategies. After this consideration, what can clearly be noticed is the overall underperformance of the so-called “risk parity” strategy, putting into question its long-term viability and potency.
The Risk Parity strategy is most famously employed by Bridgewater Associates, the world’s largest hedge fund, and is led by Ray Dalio, one of the world’s most famous investors with a net-worth of $18bn. In its “All Weather” fund, which manages approximately $70bn worth of assets, the risk parity strategy aims to diversify a portfolio by matching the volatility contributions of all assets in a said portfolio. With that, we optimize our holdings not by asset selection or expected return values, but rather by “risk aversion”, which means clients are served on the basis of their personal risk tolerance rather than their desired capital gains. The idiosyncratic asset “volatility” values will, in turn, determine the portfolio weights allocated for each asset class.
In a traditional example, in order to compensate for the higher risk that stocks carry in a portfolio, a risk parity fund would significantly increase the weights of bonds, since they are traditionally seen as “safer”, in order to arrive at the same implied “riskiness” of each asset on aggregate. The larger bond holdings therefore allow us to reduce the volatility of the portfolio, which is mainly driven by stocks. After being inaugurated in 1996, this strategy yielded impressive returns as it beat a classic “60/40 portfolio” by 30% from 2005 to 2013. It has also fared well compared to general asset classes over multiple decades.
Source: AQR Capital Management
However, if we look at the performance of major risk parity funds since January 2020, with Ray Dalio’s Bridgewater as the flagship fund, we observe heavily deteriorated returns. The S&P Risk Parity index fell as much as 28% while the 60/40 benchmark (60% stock, 40% bond allocation) fell by merely 18%. For a strategy that boasts itself by its safeness and conservativeness even in times of distress, as the name “All Weather” indicates, how can the bad performance in 2020 be explained?
Although the 2020 pandemic and bear market that followed could be characterized as a classic Black Swan event which explicably shook most investment strategies, risk parity was destined to underperform even if Covid-19 hadn’t occurred. One of the major issues of the risk-parity strategy is its dependence on leverage. In order to adjust the risk of each asset and equalize it to another, we need to lever up our bond holdings until their volatility is comparable to that of equities. In that sense, with enormous amounts of quantitative easing and central bank stimulus over the last 2 decades, it has been relatively inexpensive to lever up and obtain stock-like returns while undertaking bond-like volatility. With growing central banks’ balance sheets across the developed world, it is evident how cheap leverage benefited risk parity strategies, outperforming traditional 60/40 portfolios and posting the highest Sharpe Ratios in the industry. But why has it then been so affected by the coronavirus crash?
One simple theory is that central banks finally ran out of ammunition. With all fiscal and monetary interventions provided in the recent aftermath of the crisis, the S&P 500, along with other global market indices failed to rebound as swiftly as anticipated. Quantitative easing, the main driver of risk parity returns stopped giving the boost it has been doing for the past 10 years. Another important aspect is the long-lasting bond bull market. With bond yields being at historic lows, bonds have become so expensive that they ceased to offer the volatility hedge they once did. The gains of rising bond prices have already been captured by risk parity during the last two decades, the golden era seems to have passed. Lastly, the relative calmness of the markets over the last few years incited risk parity funds to increase their leverage positions. As volatility kept going down, leverage levels went up. In the unfortunate case of a sudden bear market and volatility rise as seen in 2020 (VIX at 80), risk parity theory suggests the need to deleverage to cover the losses, resulting in asset sell-offs that only exacerbated the funds’ troubles.
However, the main, and most critical blow to risk parity in 2020 was the unexpected correlation between stocks and bonds, which disrupted the theory and soundness behind the model. Indeed, during the worst trading weeks of the pandemic, investor sentiment coupled with government unreadiness created an unusual trend of stocks and bonds behaving in the same way. After all, the main thesis of a risk parity strategy is to partially hedge stock volatility with bond holdings. And, in the peculiar case of them moving in tandem, i.e. stocks selling off and bond yields edging higher, the risk parity strategy completely loses its effectiveness. In other words, a diversified portfolio yields negative results as the assets used to diversify it become highly correlated to each other. It is specifically this supposition of negative, or low correlation between assets that allowed levered risk parity strategies to be as fruitful as others while undertaking considerably lower amounts of risk during the past 20 years.
“Some risk parity funds that took an inverse correlation between stocks and bonds for granted have been forced into deleveraging, exacerbating market sell-offs and their own losses”, said Daniel Seiler from Vontobel Asset Management. “You reduce your volatility with a negative correlation and if that is not the case anymore, you will obviously need to reduce the volatility with a different measure, and this could deleverage your whole portfolio”.
So, should we expect stocks and bonds to revert back to old correlations?
In one sense, the market upturn created by rapid government intervention via emergency funds and bond-buying did indeed reassure markets, and made stocks gain an approximate 20% since March. With more optimistic long-term macroeconomic conjecture, sovereign bonds have also been sold off, with European sovereign yields rising slightly from the March lows. In that case, the risk-parity strategy should in theory regain its attractiveness as assets being to move inversely again. However, a legitimate question can be asked if the aggregate, decades long bond rally is likely over, has risk-parity already passed its golden era? During the past 20 years we have experienced the longest bond bull market in history, a feat unlikely to continue with analysts predicting yields can’t go any lower. Even if the proposed government rescue funds eventually pay off and stabilise the markets, will risk parity still be worth the fees investors pay compared to low-cost passive funds? Generally speaking, less effective QE and overpriced bonds would indicate risk parity strategies have had their moment in the sun.
If we look at the past 30 years, risk parity has been the best, longest running success story of the markets, making Bridgewater Associates the biggest hedge fund in the world and Ray Dalio one of the most respected investment gurus in mainstream media. Regretfully, the new economic truths of 2020 indicate his future returns are destined to be mediocre. Is now finally the time to call back “true alpha” funds, where skilled managers can genuinely differentiate themselves from the rest, rather than beta balancing ones such as these?