One year after the inflation shock wreaked havoc for diversification strategies on Wall Street, AQR Capital Management sees brighter days ahead for a popular quant trade that spreads money across assets.
(Bloomberg) — One year after the inflation shock wreaked havoc for diversification strategies on Wall Street, AQR Capital Management sees brighter days ahead for a popular quant trade that spreads money across assets.
According to the Greenwich, Connecticut-based systematic manager, so-called risk parity investing — which allocates to everything from stocks and debt to commodities based on their volatility — is ready for a revival as bonds re-establish their traditional role as a portfolio diversifier.
The thinking goes that vanilla equity strategies could be in for a tough ride given mounting recession risk, while bonds boast renewed power to hedge a downturn in shares. That’s a helpful backdrop for risk parity to outperform versus traditional portfolios, since it is typically overweight fixed income.
“Collective ignorance on the future of the macro environment is exceptionally high right now, and the best defense we have against ignorance is diversification,” said Jordan Brooks, principal and co-head of AQR’s Macro Strategies Group. “The outlook for risk parity is very positive, which is a change from recent years.”
Brooks said AQR increased exposure to bonds in the first quarter, despite recent market volatility spurred by uncertainty over the Federal Reserve’s policy path. It has also assigned more weight to commodities including gold and other precious metals which “have the nice benefit that they perform well in an inflationary environment.”
About a year ago, AQR’s research underscored the vulnerability of risk parity to the impact of rampant price growth. The firm’s warning proved prescient, and a gauge of risk parity suffered its second-worst year in almost two decades in 2022. But thanks to gains in both stocks and bonds, the index is up 8.1% in 2023 so far. AQR’s Multi-Asset Fund is up 3.5%.
AQR’s thinking now is that that the debt portion is well placed to protect the portfolio. Already, the traditionally negative link between stock and bond prices has been returning as inflation eases — meaning thanks to its haven status, the Treasury market has been rallying on days when equities fall. The 30-day correlation between Treasuries and the S&P 500 has turned the most negative in more than a year, according to data compiled by Bloomberg.
But some market watchers reckon the benign trading pattern won’t last. Deutsche Bank AG analyst Francis Yared said at the end of March that high inflation and low growth are creating a “toxic mix” for risk-parity funds, as historic patterns suggest the stock-bond correlation is negative when US core inflation is above 3%. Data Wednesday showed the core US consumer price index cooling, but still up 5.5% from a year earlier.
Unusually elevated bond gyrations in recent months alongside still-muted stock swings have also thrown a new curve ball. In theory this kind of investing climate would spur systematic funds wedded to volatility targets to boost their equity exposure and cut back on fixed income — a counterintuitive trade when many are bracing for a recession.
Brooks said AQR tweaked the way it measures the “riskiness” of individual assets about 18 months ago, broadening the definition to include drawdowns as well as volatility. Viewed through that lens, bonds have a high volatility but a naturally smaller drawdown risk, whereas “Teflon” equities have been steady — but have an inherently higher chance of succumbing to liquidations.
Equities “seem to be at a very precarious position,” said Brooks. “Stocks are pricing an immaculate disinflation.”
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