I had risk parity in mind when I noted that a recent article at Financial Advisor quoted long-time awesome bond manager Dan Fuss on the state of the bond market:
Dan Fuss, whose Loomis Sayles Bond Fund beat 98 percent of its peers in the last three years, said the fixed-income market is more “overbought” than at any time in his 55-year career as he prepares to open a fund to British individual investors.
“This is the most overbought market I have ever seen in my life in the business,” Fuss, 79, who oversees $66 billion in fixed-income assets as vice chairman of Boston-based Loomis Sayles & Co., said in an interview in London. “What I tell my clients is, ‘It’s not the end of the world, but for heaven’s sakes don’t go out and borrow money to buy bonds right now.’”
The reason this intrigues me is the strong institutional interest in “risk parity” portfolios at the moment. The base idea behind risk parity is that in a typical investment portfolio, equities provide most of the volatility. A risk parity portfolio typically tries to equalize the volatility contribution of different asset classes, which often means reducing the equity allocation—and also often leveraging the bond allocation. (Equating volatility with risk is a whole different discussion.) In other words, risk parity portfolios often borrow money to buy bonds, just the thing Dan Fuss is urging his clients to avoid right now.
To me, the marker of a bubble is irrational behavior. By that standard, bonds are in a bubble. Consider that at the end of last week the 10-year Treasury could be purchased with a yield of about 2.00%. Yet, the 10-year breakeven yield was about 2.57%, indicating that a buyer of 10-year Treasurys expected a negative real return.
Is it rational to buy something with the expectation of a negative return? Think about it this way: Imagine telling a prospective client, “If you buy this stock portfolio, we expect that you’ll lose about a half percent a year for the next decade.” Think you would have any buyers? Would people bid at auction to get a piece of the action?
Expectations, of course, could be wrong. Maybe bonds will continue to do well for an extended period of time, or maybe buying with the expectation of a slight negative return will turn out to be a genius move because every other asset class does much worse.
The problem with bubbles is not really that they exist. Bubbles are great for investors and for the economy on the way up. Bubbles often have an evolutionary financial purpose as well—probably the foundation for many later businesses was laid during the internet bubble. Much of the first internet generation might have died off, but their offspring populate Silicon Valley now. We’ll always have bubbles, human nature being what it is.
The more specific problem with bubbles concerns the investors trapped in them as they deflate—and the absolute impossibility of determining when that might happen. It’s way easier to identify a bubble than to guess when it will pop. Trends of all types, including bubbles, can go on for a lot longer than people think.
The most practical way to handle bubbles, I think, is to use some type of trend following tactical approach. You’ll never be out at the top, of course, but you might be able to be along for much of the ride and be able to exit without extensive damage. If you’re a bond market investor today that might be one way to think about your exposure. Committing to bonds as a permanent part of a risk parity strategy, especially with leverage, is a different animal.
[...] Why all the interest in risk parity portfolios now of all times? (Systematic Relative Strength) [...]
Though I haven’t seen the individual returns by year, Bridgewater has said they’ve back tested risk parity all weather portfolios through rising rate environments before and it came out ok. Perhaps equities and commodities do well enough to make up for the poor performance in bonds. A sharp rise in rates should cause bonds to have a higher volatility which would cause a risk parity fund to drop it’s weighting in bonds. But we’ll see. Personally I wouldn’t mind an all Weather portfolio as a “core” holding with a momentum/relative strength/tactical asset allocation strategy running on top of it to boost returns
Couldn’t agree with you more regarding leveraging a portfolio to invest in bonds; however, the true hallmark of a successful risk parity strategy is to include interest rate sensitive allocations (e.g. variable rate instruments, gold, hard commodities, etc.) as well as embracing tactical deviation based upon short to intermediate changes in volatility.
Any simple set and forget strategy is doomed for failure in these modern markets.
In an environment of rising rates and rates volatility is also likely to be an environment where equity and commodity and FX volatility is also rising. Therefore it is unclear whether exposure to bonds would fall or not. In addition, it is likely that correlations between asset classes will also be changing.
Risk parity does not absolve an investor from having a view about future return from asset class exposures. And if most traditional financial asset class returns are poor, risk parity won’t generate sufficiently high returns.