Click to enlarge Risk Parity has had a phenomenal year-to-date. One popular provider of the strategy for retail clients is up nearly 9% while the S&P is up a little over 3%. This is primarily due to big rallies in both the bond and commodity markets, as the Fed has continued to ease off on interest rates while the global outlook has stabilized. YTD Performance of Major Asset Classes vs. Risk Parity (labeled “You”) Source: Yahoo Finance, Federal Reserve , WSJ , Hedgewise Despite this strong outperformance, the bond rally has raised a familiar worry: what happens when interest rates rise? Given the strategy has a heavier bond allocation than most traditional portfolios, does it continue to be a viable option? Fortunately, we have decades of historical data that show that rising interest rates are not a cause for great concern. In times of high inflationary pressure, like the 1970s, the strategy is protected by assets like commodities and inflation-protected bonds. While higher short-term rates do reduce the benefits of using leverage, our backtested model still performed at least as well as the S&P 500 throughout the 70s. The absolute “worst case” scenario is one in which rates are being driven up by continuously strong real growth, such as the post-WWII economy from 1950 to 1970. In this situation, both bonds and real assets like gold will tend to perform poorly while the stock market rockets ahead. Though Risk Parity will probably underperform the S&P 500 over such a stretch, you will still make solid returns ; they simply won’t be as high compared to a portfolio of 100% equities. In exchange for this possibility, you avoid the risk that the next 2008 may be right around the corner. While rising interest rates may seem like a foregone conclusion, recent history in Germany and Japan demonstrates that rates may be just as likely to fall. In short, it only makes sense to move away from Risk Parity if you are absolutely sure we will experience a booming, robust economy over the next 20 years and you can afford a few 40% downturns along the way. If you have this conviction, by all means, move to 100% equities. If you aren’t sure, though, recall that Risk Parity is a long term investment strategy that has consistently produced reasonable returns without the need to predict the future. Modeling Performance in the 1970s: Inflation Protection Works From 1970 to 1983, the Federal Funds rate rose from 4% to nearly 20%, or a whopping 1600 basis points. The US was facing a vicious combination of rising prices and falling economic activity, also known as “stagflation”. This provided an excellent environment to pressure test the Risk Parity framework, which you might expect to do terribly given its heavy bond allocation. However, just the opposite occurred: our model outperformed equities nearly the entire time . To create the historical model, we had to make a few key assumptions: We are using a modified form of our proprietary risk management framework, as there was not nearly the amount of market data available in the 70s as there is today. Our belief is that this is a handicap, and we expect our framework would perform even better than is shown here if we had the same data available. We limited the portfolio to nominal bonds (NYSEARCA: IEF ), equities (NYSEARCA: SPY ), and gold (NYSEARCA: GLD ) because inflation-protected bonds (NYSEARCA: TIP ) did not yet exist, nor did reliable data on the price of commodities like oil and copper. The assets that we had to exclude all tend to perform well in periods of high inflation, and would likely buoy performance within our full model. Risk Parity is typically available at multiple ‘risk levels’, the higher of which amplify expected returns through leverage. We ran an unleveraged “Low Risk” version of the model as well as a leveraged “High Risk” version. The portfolios are based on end-of-day index prices and do not account for live trading conditions. All dividends and coupon payments are included and assumed reinvested. Leverage is assumed to have a cost equal to the rate on one-year treasury bonds. The model does not include the cost of commissions or management fees. Performance of Risk Parity “Low Risk” and “High Risk” Models vs. S&P 500, 1970 to 1982 Click to enlarge Source: Hedgewise Analysis Despite one of the worst decades for bonds ever in history, both versions of the Risk Parity portfolio outperformed equities for nearly this entire stretch. This was possible for two reasons. First, ten-year bonds still achieved an annualized return of about 6% during this timeframe. Even though rising rates eroded the principal value of the bonds, this was counterbalanced by consistently higher yields. Second, assets that provide protection from inflation, like gold, performed incredibly well in this environment as the value of the US dollar plummeted. That said, it is interesting to note that based on total return over the entire timeframe, the “High Risk” portfolio failed to outperform the “Low Risk” portfolio even though it was far more volatile and leveraged. This makes sense when you realize that short-term interest rates were often higher than long-term rates during this period. In other words, you were often paying more in interest than you were making back. Does this mean that using leverage doesn’t make sense when interest rates are rising? Not necessarily. The “High Risk” portfolio actually was outperforming most of the time; the net result was highly influenced by the final period in which rates rose most rapidly. Still, it is accurate to say that leverage will be less useful compared to periods of flat or falling interest rates. Taken together, these facts lead to a few important takeaways. Even if you are relatively certain that inflation is about to pick up, Risk Parity would still be a great choice . In this kind of environment, higher risk level portfolios may occasionally fail to outperform the lower risk levels, though they would all generally perform well compared to the S&P 500. If you are absolutely convinced that we are heading for another period like the 70s, you might consider avoiding leverage, but it certainly wouldn’t make sense to abandon the strategy altogether. Before we move on, keep in mind that the decade of the 70s was the earliest period of rising rates in which we had enough data to do a proper simulation of our model. When studying the 50s and 60s, we must rely on a drastically more simplistic version. Still, this severely handicapped portfolio can effectively demonstrate some of the timeless concepts of the Risk Parity Framework. Modeling Performance in the 1950s and 1960s: The Boomer Years The Post-WWII economy in the US was incredibly robust. For nearly 20 years, we experienced strong real growth with relatively limited inflation and no major recessions. The S&P 500 grew by over 10% annually, while nominal bonds returned only 2% annually due to consistently rising real rates. You’d expect a portfolio of 60% bonds would make no sense; never mind adding leverage to the mix! However, such a portfolio still provided solid, steady returns with a lower risk of drawdowns . Using leverage also successfully increased returns, though not significantly. This was true even with no active risk management and during two of the worst performing decades for nominal bonds in history! To be clear, in hindsight, equities were the top performing asset class, and any mix besides 100% stocks probably underperformed. However, this fact misses the entire point of diversification: you just don’t know what is going to perform well next. Of course you will do better if you always switch into the asset class that is about to blow the others away, but you’ll often be wrong. Risk Parity allows you to consistently do well regardless of the environment. With that said, let’s take a look at the data from these decades. Here’s how we constructed the model this time: Since data was not available to implement active risk management, we assumed a static split of 40% stocks and 60% bonds for the Risk Parity portfolio. We took this same mix and added 75% leverage, for a final mix of 70% stocks and 105% bonds. This is a simple, static performance model that is limited to two assets. Performance of our full model in the same time period would likely have been better. Performance of 40% Stock / 60% Bond Mix and Leveraged 40/60 Mix vs. S&P 500, 1953 to 1970 Click to enlarge Source: Hedgewise Analysis As expected, the bond-heavy mix was unable to keep up with equities over this timeframe. However, both the unleveraged and the leveraged versions of the portfolio still performed reasonably well from an absolute standpoint. The unleveraged 40/60 mix averaged an annual return of 5.5% with less than half the volatility of the stock market and significantly smaller drawdowns. If your goal was capital preservation and moderate growth, this portfolio may have still been a better choice. While it’s easy to argue otherwise when you look over the 20 years, stocks experienced a number of significant declines during that timeframe that may have been unacceptable for someone close to retirement or with a shorter time horizon. For example, stocks lost as much as 31% during the dips in 1958, 1962, 1966, and 1968. If you needed to exit the market during these periods, or you were actively taking withdrawals out of your investments along the way, such losses could significantly damage your outlook. With our leveraged mix, we see a similar theme to what occurred during the 70s: you will still achieve higher returns using leverage, but not significantly so. Importantly, this dispels the myth that levering up a Risk Parity portfolio will be disastrous when bonds do poorly. The leverage is not harmful; it just isn’t as helpful compared to other times. Plus, remember that the modern day version of the portfolio would likely exhibit a much smaller performance gap compared to the one shown here. The key to this analysis is deciding what it means to you. First, consider how sure you are that stocks will be the top performing asset class over the next 20 years due to strong real growth and low inflation. If we experience any other kind of environment, Risk Parity will tend to outperform. Second, evaluate how damaging each worst-case scenario might be for you personally. If you moved to 100% equities at the peak of the dot-com bubble, it took you nearly a decade to recover your losses. If you utilized a simplistic version of Risk Parity during the Post-WWII era, you still made 6.6% instead of 10.4%. As with any kind of diversification, it only makes sense if you agree that the future is quite uncertain. As much as it may seem that bonds are about to enter a prolonged bear market, there’s a good deal of evidence that suggests quite the opposite. Where Have the Rising Interest Rates Gone? Supposedly, the bond bull market in the US has been on the verge of ending for about 4 years now. There was the so-called ‘taper tantrum’ in 2013, during which yields rocketed over 100bps when Bernanke announced the end of ‘Quantitative Easing’. Yet the US economy continued to sputter along slowly and global weakness brought yields back down. In late 2015, the Fed was expected to raise rates as many as 6 times in the near-future. Then, a global collapse in commodity prices and rapidly slowing growth in China caused them to back-off again. Meanwhile, ten-year bonds have continued to hover around 2%. 10-Year US Treasury Yields Since 2000 Click to enlarge The gut reaction to this graph is to think that we must be near the bottom. However, there is no reason that we can’t fall well below a 2% yield for decades. Japan, for example, has had ten-year yields under this level for almost 20 years. 10-Year Japanese Treasury Yields Since 1990 (2% yield emphasized) Click to enlarge Many are quick to point out that our economic history is quite a bit different than Japan’s. Instead, let’s take a look at Germany: 10-Year German Treasury Yields Since 2000 (2% yield emphasized) Click to enlarge The reality is that the entire world remains in a very fragile state. On a relative basis, yields in the US are actually still pretty high. In the EU, a number of countries have recently introduced negative interest rates to continue to combat recessionary pressure. The point is that we may be at the end of the bond bull market, but it’s also entirely possible that we are not. Conclusion: Rising Rates Are Not a Big Concern The evidence presented in this article helps clarify some extremely important concerns about Risk Parity. In the thirty-year stretch from the 1950s to the 1980s, adding leverage to a bond-heavy portfolio never resulted in disaster; it just had less of a positive effect on returns. During the most inflationary period in US history, our model outperformed the S&P 500 for a majority of the time. These facts boldly refute the idea that Risk Parity only ‘works’ during bond bull markets. As with any kind of diversification, there will always be periods when one asset is outperforming the others. In exchange for tolerating this, you get steadier, more reliable returns which do not depend on you predicting the future. You become less vulnerable to a crash in any given market. You’ll tend to make money even when interest rates are steadily rising, but you’ll make less than you could have if you had perfect foresight. Even if you do have a strong conviction that rates are about to rise, an unleveraged Risk Parity portfolio remains an excellent choice for investors with a shorter timeframe because of its significantly smaller drawdowns and steady historical returns. We would absolutely recommend such a portfolio over cash regardless of the market environment. For longer term investors, be wary about the likelihood that we are about to enter a period of growth similar to the post-WWII economy. As many countries in Europe and Asia have already demonstrated, another recession may be a far bigger risk. Finally, please keep in mind that this article focused on extreme scenarios, including the naïve construction of the model portfolios and the chosen start and end dates of the analysis. If the Risk Parity framework can hold up relatively well despite these handicaps, there’s little reason to keep worrying about the specter of rising interest rates. If you are interested in learning more about Risk Parity, check out this white paper overview . We’ll also be publishing the current construction of our “Low Risk” and “High Risk” portfolios early in May. Be sure to follow us if you’d like to receive it. Disclosure: I am/we are long SPY, IEF, TIPS, GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. To the extent that any of the content published may be deemed to be investment advice or recommendations in connection with a particular security, such information is impersonal and not tailored to the investment needs of any specific person. Hedgewise may recommend some of the investments mentioned in this article for use in its clients’ portfolios. Past performance is no indicator or guarantee of future results. This document is for informational purposes only. Investing involves risk, including the risk of loss. Information in this document has been compiled from data considered to be reliable, however, the information is unaudited and is not independently verified. Performance data is based on publicly available index or asset price information and does not represent a live portfolio except where otherwise explicitly noted. All dividend or coupon payments are included and assumed to be reinvested monthly.