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Can risk parity withstand rising rates?

Feb 9, 2017

We believe that risk parity’s diversified approach serves it well in rising rate environments, because the strategies allocate to growth and inflation—the principal factors that drive rates higher.

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With interest rates rising, some investors are concerned about the prospects for risk parity strategies, which use substantial allocations to bonds to seek improved diversification over traditional balanced portfolios.

But this view misses three important points. First, fixed income may deliver positive returns in a rising rate environment. Second, bonds provide a vital strategic component of a diversified portfolio, and trying to time the market is very difficult. Third, risk parity is not dependent on falling bond yields.

We advocate diversified strategies that are not dependent on any single asset class or economic outcome (such as falling interest rates or strong economic growth) to generate returns.

By seeking balanced exposure to the different factors that drive asset class returns, we seek to build strategies that are robust in a variety of scenarios, without over-relying on any one source of return.

Diverse regimes require diversifying assets
Average returns by asset class for different economic environments

 

Global asset classGrowthDeflationary falling growthInflationary falling growth
Nominal bonds 0.3% 5.9% 1.0%
Real bonds 4.9% 0.9% 3.5%
Equities 9.1% 4.4% -4.7%

Source: Bloomberg, as of 11/30/2016. Nominal Bonds: Citigroup WGBI Currency Hedged 7-10yr USD 1/1972-11/2016; Equities: MSCI World USD Index 1/1972-11/2016. Analysis begins in 1972 to capture the subsequent period of high inflation. Real Bonds: Barclays World Inflation Linked Bonds TR Hedged USD 1/1997-11/2016. Real bonds did not begin trading until 1997.Growth rising/falling is defined by a 3-month increase/decrease in the U.S. ISM Manufacturing Index. Inflation rising/falling is defined by a 3-month increase/decrease in the 12-month percentage change of the U.S. PCE Index.

Ked Hogan, PhD
Head of Investments for BlackRock’s Factor-Based Strategies Group
Philip Hodges, PhD
Head of Research for BlackRock’s Factor-Based Strategies Group
Trey Heiskell, CFA
Senior Investment Strategist for BlackRock's Factor-Based Strategies Group