You own bonds to offset the risks of stocks and vice versa, but what happens when they both go down in extended bear markets? From Harris “Kuppy” Kupperman at wolfstreet.com:
When something that is this widely adopted blows up, it tends to blow up spectacularly.
By Harris “Kuppy” Kupperman, founder of Praetorian Capital, Adventures in Capitalism:
For four decades, the US stock market has traded up and to the right. During those brief moments of setback, treasuries rallied strongly. The fact that these two asset classes seemed to offset each other, creating a smoothed-out return profile, was not lost on certain fund managers who created portfolios comprised of the two. Then, to better market this portfolio to the sorts of institutional investors who cannot bear drawdowns, the overriding strategy was given the pseudo-intellectual sounding Risk Parity moniker.
Over time, the reliability of Risk Parity funds has astonished most observers, especially after being tested by fire during the GFC. As a result, portfolio managers took the logical next step and added copious leverage—because in finance, when you do a back-test, every return stream works better with leverage.
Naturally, as Risk Parity continued to produce returns, inflows bloated these funds. Risk Parity strategies, in one form or another, now dominate many institutional asset allocations. While everyone makes their sausage a bit differently, trillions in notional value are now managed using this strategy—long equities, long treasuries. Are they highly-leveraged time-bombs??
Taking a step back, it’s important to ask, what created this smooth stream of Risk Parity returns? Was it investor brilliance or was it a four-decade period of declining interest rates that systematically increased equity market multiples while reducing bond yields? What if all the sausage-making was just noise?