Morningstar Advisor - April/May 2013 - (Page 42)

Spotlight The Risk-Parity Approach By Samuel Lee A relatively new way to construct portfolios says many investors aren’t truly diversified. The future delights in humiliating seers. In 2007, who would have predicted that the rich world would reprise the Great Depression? And yet here we are: The U.S. government can run annual deficits amounting to 9% of GDP, triple the monetary base to $2.6 trillion in a few years, and still issue 30-year bonds yielding 3%. The surprising frequency of the “unthinkable” happening suggests we are overly confident in our ability to see the future. The “risk-parity” approach to portfolio construction is a powerful way to combat this mistake. Pioneered by Bridgewater Associates, modern risk-parity portfolios adhere to a simple principle: Balance portfolio exposures across all the major economic scenarios by volatility. The hope is that such a portfolio will perform well in all economic climates— and indeed, risk-parity strategies have. The strategy is gaining influential adherents, mainly among institutions, but hasn’t caught on with advisors and individuals. Will this strategy work in the future? Could a client apply it? I think the answer is, tentatively, yes to both questions. To understand why risk-parity works, we have to revisit a common fundamental misconception of portfolio construction. 42 Morningstar Advisor April/May 2013 The typical investor thinks of assets as being like indivisible elements, with distinct characteristics. In contrast, the risk-parity approach begins with the observation that asset classes can be described in much the same way atoms can be described as combinations of electrons, protons, and neutrons. This isn’t a modern insight, but one that’s been around academia for decades. The risk-parity application is relatively new, however. The Four Economic Configurations Economies have four main configurations, characterized by combinations of rising/falling inflation and rising/falling economic growth. Changes in inflation and economic growth can explain the gross behavior of almost any asset class. Percent of Months in Each State, 1928–2012 Inflation (%) According to Bridgewater, the fundamental particles in the risk-parity view of the world are inflation and economic growth. A 2012 paper (“The Risk in Risk Parity: A Factor Based Analysis of Asset Based Risk Parity,” by Vineer Bhansali, Josh Davis, Graham Rennison, Jason Hsu and Feifei Li) confirmed this observation, finding global growth and global inflation could explain the majority of the behavior of a variety of asset classes. Standard portfolio construction advice does not lead to risk-balanced portfolios. The typical 60% stock/40% bond portfolio’s volatility is 90% determined by equities, which are reliant on stable inflation and economic growth. What happens when inflation ticks up or growth slows? Standard portfolios fail. Disinflation (%) 42.5 39.2 7.4 11.0 Growth Recession See methodology note an end of article. Naturally, in each phase of the business cycle, different assets are king. Stocks do best when the economy is growing and inflation is falling, coinciding with the recovery phase after a recession; bonds do best when the economy is tanking and inflation is falling, coinciding with the downward leg of a conventional recession. These are sensible relationships. Stocks rise in anticipation of increased earnings growth, and bonds rise when inflation or interest rates fall. For the most part, it doesn’t really matter what kind of stocks or bonds you own—whether they’re growth/value or corporate/Treasuries—each asset class will largely obey its relationship to economic growth and inflation.

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2013

Morningstar Advisor - April/May 2013
Contents
Contributors
Letter From the Editor
The Pursuit of Happiness and Financial Advice
What Strategies Do You Use to Control Risk?
Driven to Succeed for Clients and Family
How to Assess a Portfolio’s Bond Risk
Luck, Skill, and Investing
Investments á la Carte
Investment Briefs
Investing’s No- Brainers Have Costs
A Defensive Ride
Risk On/On Risk
The Risk of Being Overconfident
Year of Living Dangerously
The Risk-Parity Approach
A Guide to Mutual Funds Running Risk-Parity Strategies
What Moats Tell Us About Risk
Risk’s Wake-Up Call
Seeing Is Believing
Why Investors Lag the Returns of Their Funds
Liquidity Signals
Pump Them Up
Golden Oldies Keep on Truckin’
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Our Social Blind Spot

Morningstar Advisor - April/May 2013