Fashionable ‘Risk Parity’ Funds Hit Hard; Strategy, Using Leverage to Boost Returns, Hurt by Market Tumult

June 27, 2013, 8:44 p.m. ET

Fashionable ‘Risk Parity’ Funds Hit Hard

Strategy, Using Leverage to Boost Returns, Hurt by Market Tumult

MICHAEL CORKERY, CAROLYN CUI and KIRSTEN GRIND

Investors who piled into “risk parity” funds, which follow a popular strategy that promises to make money in most environments, are being hit hard by the current market turmoil. The losses are touching a broad swath of investors, ranging from hedge-fund firms Bridgewater Associates LP and AQR Capital Management LLC, to mutual funds and local pension funds. Risk-parity funds use leverage to try to increase returns on bond investments so they more closely resemble returns of stocks. The basic idea of the strategy is that by equally distributing risks among stocks, bonds and commodities, the portfolio can weather huge price swings without sacrificing returns.These type of funds have consistently outperformed traditional strategies since the financial crisis and have soared in popularity. Assets in risk-parity mutual funds totaled $15.1 billion at the end of May, up from $73.6 million at the end of 2008, according to fund-research firm Morningstar Inc.MORN +0.51% Some estimate there is as much as $200 billion in total in risk-parity assets.

The recent market turmoil has tested many followers of the strategy. That is mostly because stocks have tumbled along with bonds after the Federal Reserve hinted at a reduction in its stimulus program last month. Making things worse, commodities and inflation-protected securities, which are widely used by risk-parity managers as a hedge against inflation, also suffered heavy losses because of receding inflationary expectations.

“We don’t expect to make money every year,” said Bob Prince, co-chief investment officer of Bridgewater, which regards itself as a pioneer of risk parity. Bridgewater’s $75 billion “All Weather” risk-parity fund is down about 8% for the year, according to a person familiar with the returns.

Risk–parity mutual funds have lost an average of 6.75% this year, according to Morningstar. Meantime, a stock-and-bond index comprising 60% of the S&P 500 stock index and 40% of the Barclays BARC.LN -0.90% U.S. Aggregate Bond Index, a widely used bond benchmark, is up 6.76% this year, according to Morningstar. Risk-parity proponents often argue that their strategy is designed to beat a so-called 60/40 portfolio of stocks to bonds.

Mr. Prince said Bridgewater was clear with investors that risk parity suffered losses in the financial crisis in 2008—and could suffer them again—in the event that the Fed tightened its monetary policy. Mr. Prince said no investors have sought to withdraw from All Weather as a result of the recent losses, and the fund has had investor inflows. All Weather has returned an average of 9.5% a year since its inception in 1996.

Many of risk parity’s followers have been counting on the strategy to generate solid returns under almost any circumstance, particularly in rocky markets such as the current one.

“Investors have come to view these as really defensive types of vehicles, so expectations are being disappointed,” said Josh Charlson, a senior mutual-fund analyst at Morningstar.

The strategy was first adopted by hedge funds but is now offered to individual investors through a handful of mutual funds.

Risk-parity mutual funds saw a collective net inflow of $337.5 million of investor money in May, according to Morningstar, the most-recent data available and before the stock market dropped sharply.

Invesco Ltd.’s IVZ +1.85% $12.8 billion Balanced-Risk Allocation Fund, which is one of the largest risk-parity mutual funds, has lost 4.18% so far this year, according to Morningstar.

The asset-management company reduced its bond exposure by 25% after switching to a new risk model about a year ago, which has helped offset some losses, said Scott Wolle, chief investment officer of Invesco’s Global Asset Allocation group. Overall, Invesco had $24 billion risk-parity assets by end-May, up from $19 billion in March.

While rising interest rates have hurt all bond investors, the use of leverage is magnifying bond losses in risk-parity funds, investors say. Risk parity typically achieves leverage through the use of futures and other derivatives.

A move by the Fed to pull back on its easing could trigger another point where stocks and bonds fall at the same time, potentially for a more-sustained period, which would be bad news for risk-parity investors.

Officials in Fairfax County, Va., have structured most of their $3.5 billion employees’ pension portfolio along the risk-parity model. Through the use of leverage, the employees’ pension plan has about 80% exposure to bonds.

The pension plan lost about 2.5% in May and could lose an additional 2% in June, said Larry Swartz, chief investment officer. Still, like many risk-parity investors, Fairfax County officials believe that the strategy will outperform over the long term, despite a few bad years. Over the 10-year period ended December 31, the Fairfax employees’ pension plan had an average annual return of 10.4%.

In 2008, during the financial crisis, when stocks and many types of bonds fell at the same time, the Fairfax plan’s returns were below the median pension return. This correlation—when different types of assets are moving in the same direction—is high at the moment.

“The increased correlations have hurt us more than anything else,” said Ed Peters, co-head of global macro strategies at First Quadrant L.P AMG +2.11% ., an investment company with $1.9 billion in risk-parity strategy. Those investments were down 5.13% in May and continued to decline in June.

“There are going to be environments where it massively outperforms and there are going to be environments like the last couple of months where it underperforms,” said Michael Mendelson, a principal at AQR who is a portfolio manager for the hedge-fund firm’s risk-parity strategies. “It’s going to go both ways,” he said, adding that risk-parity should outperform a traditional portfolio over the long-term.

AQR, which started running the strategies in 2006 to manage internal money, now manages roughly $27 billion in its risk-parity funds. Its risk-parity mutual fund was down 5.7% for the year through Wednesday.