Growth of risk-parity funds
U.S. investors have poured into “risk-parity funds” in the last few years. Advocates say the complicated strategy of investing in stocks, bonds and commodities offers better returns than traditional balanced funds that invest in a mix of stocks and bonds.
Date*….. Net invested assets
2009….. $388 million
2010….. $998 million
2011….. $3.4 billion
2012….. $9.1 billion
* Year-end totals. 2012 figure is as of the end of August.
Source: Morningstar
Big fish in a small pond
Atlanta-based Invesco dominates among the handful of firms that have offered risk-parity funds to individual investors.
Fund name…… Net invested assets*
AQR Risk Parity….. $825 million
Invesco Balanced-Risk….. $8.7 billion
Managers AMG FQ Global Essentials …..$129 million
Putnam Dynamic Risk Allocation….. $150 million
Salient Risk Parity….. $73 million
Columbia Risk Allocation….. $12 million
* As of the end of August, 2012
Source: Morningstar
Wall Street’s rocket scientists have landed on Main Street.
Borrowing strategies pioneered by hedge funds, Atlanta-based Invesco and a handful of other money managers now offer mutual funds to average investors that use a complex mix of securities tied to stocks, bonds and commodities to boost returns and limit risks.
These so-called “risk-parity” funds are designed to offer investors a souped-up but safer alternative to the traditional “balanced” mutual funds — typically a mix of stocks and bonds — favored by conservative investors. The idea took off after the 2007-2009 stock market crash. Its advocates say balanced funds fared poorly because 90 percent of the risk came from stocks, even though they’re typically only 60 percent of the funds’ assets.
Risk-parity funds go beyond the traditional method of diversifying risks. Besides holding a mix of domestic and international stocks and bonds, risk-parity funds invest in commodities, such as gold or gasoline, whose prices may rise when stock or bond prices fall. Money managers also use computer programs and derivatives such as futures to re-tool the mix so that all parts of the portfolio carry equal risk — hence the term “risk parity.”
The idea is to engineer a portfolio that is less sensitive to the ups and downs of stock and bond markets, and inflation. They aim “to win by not losing,” said Christian Ulrich, a portfolio manager on the Atlanta team that launched Invesco’s version of the strategy in 2009, as the financial crisis was whetting investors’ appetite for a less risky alternative to stocks.
“It’s not your grandmother’s mutual fund, but it’s designed to be [like] your grandmother’s mutual fund,” said Wes Moss, chief investment strategist at Capital Investment Advisors in Sandy Springs. “Even though there’s more cogs and more parts in the engine moving, that doesn’t mean it’s more risky.”
But some investment experts say the complicated portfolios are unproven and may saddle investors with risks they don’t understand. “They are more sophisticated [investments],” said Josh Charlson, senior mutual fund analyst for Morningstar. “Hopefully investors are aware of it.”
According to Morningstar, six firms including Invesco have launched risk-parity mutual funds in the U.S. in recent years, with total assets of $9.1 billion.
“They pretty much all came out after the financial crisis,” said Terry Tian, a Morningstar analyst of alternative investment funds. He said risk-parity funds have done well compared with traditional balanced funds, partly because they have a bigger stake in bonds, which have done well since the market crash.
Invesco was the first money manager to go after Main Street investors in a big way with the new type of fund. And it has paid off. Invesco’s Balance-Risk Allocation funds have become the company’s fastest-growing product, recently drawing $1 billion a month in new cash. It is by far the largest player in the new field, with $8.7 billion in its U.S. funds for individual investors. It has almost $16 billion overall in such overseas and domestic funds for individuals and big institutional investors, such as pension funds.
“We think there’s quite a future for it,” said Marty Flanagan, chief executive of Invesco, which has $670 billion under management. He expects Invesco’s new funds to eventually be part of many employees’ pension and 401(k) retirement plans.
So far, risk-parity funds have worked as advertised, producing above-average returns with lower-than-average risks compared to traditional balanced funds. Since it was launched in mid-2009, Invesco’s main Balanced-Risk fund’s average annual return has topped 10.5 percent, even after deducting a hefty upfront charge of up to 5.5 percent. That earned it a five-star rating from Morningstar.
By comparison, the typical balanced fund of domestic and foreign stocks and bonds had an average annual return of about 8 percent, with higher risk, according to Lipper.
The new funds have helped Invesco’s prospects at a time when investors are still leery of stock funds, according to industry analysts.
Earlier this month, Jefferies analyst Daniel Fannon boosted his target stock price for Invesco from $26 to $31. He noted that the Balanced-Risk funds’ asset growth has accelerated since earning top ratings for its three-year performance. With capacity to grow its U.S. version from $9 billion to around $30 billion or $40 billion, Invesco has “plenty of run room,” he said in a recent report.
Still, if the stock market continues its recent rally, “this fund will underperform,” he cautioned, because of its low exposure to stocks.
Indeed, a number of experts advise caution regarding the new-fangled funds, for a variety of reasons.
While they’re a good idea for some people, risk-parity funds are largely computer-driven and unproven, they say, and may saddle investors with more risks than they expect. Also, these funds may fare poorly when interest rates rise from their historic lows, driving down bond prices.
“Main Street should take a look at this,” said Moss, but investors need to understand what they’re signing up for. The new funds give mom-and-pop investors access to tricks of the trade usually available only to big institutions and wealthy individuals, he said.
But the funds are largely “run by mathematics,” he added. They’re “running a kind of hedge fund that is timing the market,” he said. “That can work for a while, but it never works forever.”
In practice, such portfolios contain large stakes tied to bonds, which generally have lower risk and returns than stocks. To boost expected returns — and risks — closer to that of traditional balanced funds, managers use leverage created by futures or other derivatives.
Like putting a down payment on a house, such futures contracts allow investors to bet on a large pool of stocks, bonds or commodities — say all the stocks in the Standard & Poors 500 index — with a partial payment. That’s why, at the end of August, Invesco’s Balanced-Risk fund for U.S. investors had 38 percent of its $8.7 billion portfolio in stock derivatives, 27 percent in commodities derivatives, and 72 percent in bonds derivatives — 137 percent of its total portfolio value.
Such a strategy magnifies both gains and losses. “Any time leverage is in play, you do have some risk if there’s a sudden market move in the wrong direction,” said Charlson of Morningstar.
However, Invesco’s money managers say their portfolios are carefully designed to control the risk of such leverage.
During the recent financial crisis, derivatives became a “four-letter word,” said Scott Wolle, head of the Invesco fund’s team, when securities tied to subprime mortgages caused the implosion of some big Wall Street firms. But Wolle said Invesco’s approach is “simple” and transparent” by comparison.
He said Invesco uses limited leverage, mostly tied to bonds, its least risky assets. The fund keeps large cash reserves on hand. Also, he said the portfolio only buys standardized derivatives tied to the biggest markets. Those are much better understood and more extensively traded than the mortgage-backed securities that turned out to be toxic, he said.
Likewise, he said Invesco tested its computerized investment model using market data going back to the mid-1970s. The funds have also had several real-world tests since they were launched, he said, including the Greek debt crisis and continuing financial market strains in Europe.
“Those things have been through the stress tests and they haven’t broken,” he said.
“I think I would rather own this portfolio than a portfolio of [U.S. Treasury bonds],”’ said Invesco’s Flanagan, since the latter assets will drop in value when interest rates rise.
But is Main Street ready for risk-parity funds?
Some hedge funds and big institutional investors have been using risk-parity strategies for decades, but “this is definitely pretty new stuff for common investors,” said Tian, with Morningstar. And while it’s designed to be safer than a lot of traditional or alternative investments, he added, “I wouldn’t recommend this for the average investor unless they understand the inherent risks of this strategy.”
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