Risk parity funds and the post-NDX investor
Odean B. White, GUEST COLUMNIST
Since the IMF board approval of the Government of Jamaica's (GOJ) new extended fund facility on May 1, the local financial markets have been characterised by low interest rates, relative stability in the foreign exchange market and a more or less nonchalant stock market.
Additionally, with the GOJ to benefit from periodic drawdowns on multilateral foreign loans for budgetary support, the local capital market is expected to be moot going forward, for at least the next few months.
These factors translate into what some persons may view as lukewarm circumstances for medium- to long-term financial investment opportunities locally.
An alternative that fund managers could contemplate is a risk parity fund (RPF).
RPFs are mutual funds designed to navigate varying economic conditions while delivering consistent risk-adjusted returns.
The risk parity approach has its foundation in the institutional sphere of pensions and endowments. For example, hedge fund firm Bridgewater Associates was the first to employ a risk parity approach when it launched its All Weather Fund in 1996.
Today, there are 14 risk parity funds available to investors globally. Since their proliferation in 2009, risk parity funds have pulled in about US$30 billion - US$16 billion of which has occurred over the last year or so.
RPFs are similar to traditional balanced funds, except that they allocate resources based on risk, while balanced funds allocate resources based on asset classes. For example, a balanced fund may allocate 60 per cent to stocks to capitalise on market rallies and 40 per cent to bonds to preserve income when the market dips.
The downside to the balanced fund approach is that stocks tend to be more volatile than bonds. Accordingly, balanced funds which invest heavily in stocks tend to be much riskier than investors realise. On the other hand, RPFs allocate resources with a view to equalise risk across stocks, bonds and commodities.
Under this approach, stocks ensure optimum returns during periods of low inflation and sustained economic growth; high-quality bonds ensure income preservation during an economic recession; and commodities allow the fund to yield positive returns when inflation heats up.
In light of the equitable distribution of their risk feature, RPFs such as the AQR Risk Parity Fund (AQRIX) and Invesco's Balanced-Risk Allocation Fund (ABRYX) have better risk-adjusted returns when compared to their balanced fund counterparts according to their respective Sharpe ratios.
By way of definition, risk-adjusted returns reflect the extent to which the performance of a fund is a result of superior investment strategies or undue risk-taking by fund managers.
The measure that is widely used to assess risk-adjusted returns on a comparative basis is the Sharpe ratio. Incidentally, if one were to scrutinise the nominal or absolute returns of the AQRIX and the ABRYX, they perhaps would not be impressed.
The ABRYX and AQRIX have each yielded nominal returns below 2.0 per cent for the first five months of 2013. These performances are mild when compared to the Standard & Poor's 500 Index which has grown by about 13 per cent for the first five months of 2013.
This disparity, however, is not unusual given the fact that risk parity funds in general aren't designed to capture the full extent of a market rally. In other words, potential investors should be prepared to give up some nominal short-term gains for sustained risk-adjusted returns on their investments over the medium to long term.
RPFs are becoming more popular because investors are realising that they can't afford to have their retirement savings skewed too heavily towards equities - in case the market goes into another free fall akin to the post-2007-2008 financial crisis.
However, potential investors should carefully weigh the pros and cons of RPFs prior to investing. Apart from the fact that these funds have limited performance track records - only four years of returns data - their inherent equalisation of risk is engineered through the use of leverage and financial derivatives.
If you don't understand how leverage and financial derivatives work, you should not invest in risk parity funds without first consulting with a licensed financial adviser and a tax consultant to delineate any tax implications.
This is important because like with any other innovative investment product, there are always some not-so-apparent, non-trivial factors to consider. For example, a rational investor should not only look at the prospects of earning sustained risk-adjusted returns; there is also the issue of exorbitant management fees, personal risk appetite and the need to sift the 'commissions-hungry' financial advisers or fund managers with ulterior/selfish motives.
Odean B. White is senior manager, treasury at RBC Royal Bank Jamaica Limited. Send feedback to Odean.firstname.lastname@example.org