In Bridgewater Associates' second research note on risk parity in the month of September alone, Ray Dalio and his crew felt the need to explain the concept once again following a 4.2 percent August loss using the strategy, which also fell in July. While other banks have explained the strategy, most clearly done by Credit Suisse and most notably done by JPMorgan, the Bridgewater research note attempts to clarify the firm's unique implementation of risk parity, according to a memo reviewed by ValueWalk.
As the Fed fails to hike, central bank policy appears as one catalyst to negative performance
As the U.S. Federal Reserve today takes the bold move to keep interest rates unchanged, announced in a statement today at its September meeting, risk management strategies going forward are likely to move closer to center stage. Top noncorrelated Hedge Funds are anticipated to provide positive or at least relatively neutral performance during significant market downturns, as evidenced by hedge funds such as Balyasny Asset Management’s relative value strategy being relative flat and Conquest Capital, whose algorithmic strategy alternates allocations to one of four primarily managed futures strategies was up 17.81 percent in August. It is during negative stock market environments that a noncorrelated fund displays its unique value.
Experiencing unexpected negative performance is an inevitable fact of life and has happened to all great hedge funds. Understanding why a noncorrelated fund missed meeting performance expectations, when neutral or negative correlation to the stock market matters most, is an obvious question on the top of institutional minds. This is where Bridgewater’s second piece explaining risk parity comes into play. In many respects the full strategy note mentions central bank policy more than any single economic factor contributing to the negative market environment, yet a clear understanding of the portfolio balancing mechanics remains less clear.
In a strategy note out this week, Bridgewater once again explained risk parity while attempting to explain why negative returns were generated in August.
The risk parity portfolio adjusts leverage between stocks and bonds to enhance performance. “By appropriating the risks better by levering low risk assets and/or deleveraging high risk assets so that they have more parity and using these adjusted assets rather than just the unadjusted ones we can create a better balanced portfolio," he wrote.
The report touched on several interesting concepts to which some in the algorithmic investing community will relate. Bridgewater essentially called for the need to rethink volatility and risk. Standard deviation and volatility does not equate to risk. While the document left alone the Sharpe Ratio when discussing standard deviation and volatility as an inappropriate measure of risk -- the formula provides equal treatment to upside and downside deviation -- the report primarily touched on higher concepts, pointing to the reason many institutions are invested with Bridgewater.
“Diversification reduces risk and can be used to reduce risks without reducing returns,” he wrote, a theme of the little discussed noncorrelated investment movement. “Diversification improves the ratios of return to risk.” The impetus behind a risk parity strategy, the report observes, is to better diversify.
This all sets up the big question: Why did Bridgewater experience losses during the recent market downturn?
Bridgewater performance attribution: Risk parity loses money when assets have a lower return than cash
Some professional fund managers, when speaking to internal portfolio managers or when professionals speak to one another, typically move right to the point. In the case of identifying causation for losses, they might cite the portfolio component that faltered. For instance, in a recent interview with Marc Malek of Conquest, when asked by ValueWalk to attribute his double digit positive August performance along with his negative 2012 performance, he quickly reviewed the performance drivers in the portfolio to highlight the sleeve that delivered negative returns, a clear strategy definition and then explanation of how the negative performance relates to a market environment. Bridgewater takes a more circular route by touching on the larger economic situation:
Risk parity loses money when a diversified portfolio of assets has a lower return than cash. This happens when a central bank’s tightening is enough to raise the discount rate used to calculate the present value of the assets cash flows, thus lowering their present values. This is because the world economic system depends on central banks making cash available at interest rates that people can borrow.
Another way to say this is that the long equity exposure in the portfolio delivered negative performance. While the next question might be to determine the fund’s long / short ratios, or in a risk parity strategy, attempt to determine the level of selling that occurred during the downturn, the leverage adjustments and discuss the losses from a portfolio construction standpoint, the world's largest hedge fund looks at the larger picture.
Bridgewater rather backs this somewhat weaving analysis by noting that proper diversification is “not just a theoretical statement,” but rather a concept that has been back-tested. “Throughout history, the times in which a well-diversified portfolio of assets underperformed cash for any significant period of time were times of great depression and were always followed by central banks doing all in their power to rectify that. The worst performing periods were in the Great Depression and in the 2008 financial crisis, and in those periods our balanced portfolio did materially better than stocks or a 60/40 portfolio.”
Bridgewater risk parity implementation is unique relative to hedge funds
The Bridgewater document took pains to differentiate its risk parity strategy from others, where asset allocations change as perceived market risks change.
Engaging in a question and answer session with itself, Bridgewater answered the question on everyone’s mind: Why has the All Weather portfolio underperformed recently and is the indicative of what to expect going forward?
“A less diversified portfolio will outperform a balanced portfolio when the environment happens to be particularly favorable for the asset class in which the less diversified portfolio is concentrated,” the report said, highlighting a basic concept. “We’ve heard various theories about why All Weather has underperformed more traditional approaches over the last few years, but the real reason is actually quite simple. A concentrated portfolio will outperform a more diversified one when the asset in which the portfolio is concentrated happens to outperform assets overall.”
The report concluded that the forward facing market environment might not look healthy. “All assets look expensive, central banks are dangerously short on ammunition and the global economic risks are rising.” Cash is one alternative, as is investing in assets that will perform best during negative market environments, the report said, but “we would certainly be very humble about the degree to which we could know” which assets match the market environment. “We do not love any of these choices.”
The best choice is a balanced portfolio, the report said, but failed, from this reporter's perspective, to outline this concept using the appropriate language of noncorrelated investing. The report touched on the high level concepts, but didn’t roll-up the sleeves and talk a language that really exposed its August performance attribution.
“It is worth remembering that in the worst crises in history (e.g. 1929 or 2008) a balanced portfolio even with its modest leverage was far safer than traditional portfolios that are concentrated in equities,” the report concluded.
The note from Dalio was first reported by Robin Wigglesworth of the Financial Times earlier this week.
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