essays pieces of the puzzle
Monday, June 24th, 2013
risk disparity

13 0624 risk disparity

One of the popular strategies of late — well, popular at least until the last few days — is known as “risk parity.”  I picked out a Wall Street Journal article on risk parity mutual funds from February 2012 and did this chart, which starts when the youngest of them began trading in September 2011.

The funds are AQR Risk Parity (AQRNX), Invesco Balanced-Risk Allocation (ABRZX), Putnam Dynamic Risk Allocation (PDREX), and Managers AMG FQ Global Esssentials (MMAVX).  They range in size from $112 million to almost $13 billion.  I just took the share classes as were linked to in the article; a couple of them have those big, fat, upfront sales charges (so the returns above would be lower still) and the two others are no-load vehicles.

No doubt they vary in strategy to some degree, but look at what has happened of late.  What is risk parity?  Here’s a description from AQR that appeared on Advisor Perspectives back in 2010.

In the institutional world, all eyes are on Bridgewater’s $70 billion All Weather strategy, which has taken on some water of its own.  (Pensions & Investments reported late today that the “iconic risk-parity strategy” has recently been “tweaked” through the addition of some hedges.)  Individual investors following the big boys via the funds above have gotten all wet too.  Since May 9, they are down between 8.6% and 14.2%.

At the 2012 CFA Institute annual conference, when Eugene Fama was “asked about risk parity asset allocation, he said he’d never heard of it, but that the concept sounded ‘stupid.’”  (Here’s a posting about Fama and Daniel Kahneman.)

Yet, it got to be popular as one of those “can’t miss” strategies with fancy Sharpe ratios (see below).  Instead of living up to their names, they demonstrated a risk disparity that is evidenced time after time in the market:  The risk you have been living is different than the one coming tomorrow.  (Chart:  Bloomberg terminal.)

the sharpe edifice

Over the last couple of decades, the Sharpe ratio has come to be viewed as the “gold standard” of metrics for manager selection and strategy perfection.  Too bad all is not what it seems to be in the sharpe edifice.