Given the recent conversation about risk parity at MFO, I found
this M* interview with GMO's Ben Inker pretty interesting. Sayeth Ben (emphasis added):
"The different risk parity implementations have different underlying assumptions behind them, but what a lot of them tend to assume is that the correlations between assets are going to be low. What the events of this spring showed is that's not always true, and
what we think it's important for people to realize is what happened in May and June wasn't this weird, random event, meteorites striking the Earth in a way that's not (going to) happen again and could never be predicted. This is what you should expect to happen if cash rates normalize. It's not a guarantee that they will normalize, but it's a risk that's sitting there if you put together a portfolio and said, it's okay to lever this thing because the low correlations mean I'm going to be taking losses on one thing while I've got gains on another. That is absolutely not guaranteed to happen. You can rely on it less today given how low rates are than you could under normal circumstances.
"
The other problem we see with risk parity is that it's assuming that risk premia exist rather than checking to see if they exist before investing. So the assumption was that even at a yield of 1.6% on the 10-year, that 10-year bonds offered a risk premium over cash, it was far from clear to us that at those levels they did. Now, maybe at a 2.5% yield they do or certainly at a 5% yield they would, but the two things we think you've really got to look out for, and that we think in various ways a lot of the managers of risk parity ignored, were, first and foremost,
the correlations that they're assuming are going to be low are not always low, and we're in one of those situations where they could easily be higher in important and dangerous ways for an extended period of time.
"The second one is that just because an asset class has provided a return above cash historically does not mean it's priced to do that today.
Levering up an overvalued asset class doesn't make it cheap. It is just a recipe for losing money."
He also has some interesting things to say about EM equities and debt; worth a full read, IMHO.
Comments
The Wall Street Ranter
But here's my problem with "experts"
Kinnel: Emerging markets are the brightest spot of your forecasts with a 7% real return forecast, which is interesting given that this year a lot of the news has been about a slowdown in China.
Inker: Well, we have not actually been acting as if we believed that 7% forecast. That 7% forecast is assuming everything goes back to normal....
OH REALLY? Furthermore...
As a result, we have been more cautious on emerging markets than our forecast would suggest, and we still are...Emerging markets have some real problems, and we are trying to figure out exactly how they will play out.We still think you've got to own some, because they are pretty cheap even if they do have some problems.
...then it's not just that you get a bumpy ride, but you're not going to get the 7%. And that's what worries us more. We're perfectly happy to take a volatile 7%, and again we do own emerging markets and may well start buying some more over the next couple of months,
So then WTF did you make the forecast? So others would buy first and you would buy when you felt it was time to time the market? So you can make the forecast, not really do what you say, but still say you were right all the same whenever it is convenient?
Regards,
Ted
Turkey#! :https://www.aqrfunds.com/OurFunds/GlobalAllocationFunds/RiskParityFund/Overview.aspx
Turkey #2: https://www.aqrfunds.com/OurFunds/GlobalAllocationFunds/RiskParityIIHVFund/Overview.aspx
Turkey#3: https://www.aqrfunds.com/OurFunds/GlobalAllocationFunds/RiskParityIIMVFund/Overview.aspx
Regards,
Ted
http://quotes.morningstar.com/fund/gmwax/f?t=gmwax
My question is what is the track record of all the *experts* who somehow have made the AQR risk parity funds groupthink MFO must have funds ????
Edit: I should probably add that I am not targeting Charles here. These risk parity funds were groupthink funds here long before he came on board.
Correlation coefficients are not static entities. They may have nice long-term statistical averages, but they are dynamic over shorter timeframes. It’s like the story of a man drowning while attempting to cross a stream with an average depth of a modest 2 feet. The tragedy was caused by the unknown dangerous water depth at mid-stream.
Any investment strategy that is based on an invariant correlation coefficient is exposing itself to substantial hurt and perhaps even risking ruin. The historical database clearly demonstrates the dynamic correlation relationships between individual holdings and categories of the marketplace. Correlations are compliant subjects of both group and individual market perceptions. The interactions are complex and defy characterization.
Regardless of what correlation coefficient values exist in a placid trading environment where prices move slowly as a function of modest supply/demand imbalances, these same correlations accelerate towards a perfect One level as bubbles approach their critical bursting point. The 2008 equity meltdown serves as an excellent illustration of this phenomena; there was literally no place to hide.
Correlation differences among candidate holdings are a great tool to help designing a diversified portfolio to reduce overall portfolio risk by attenuating its volatility (standard deviation) while sustaining projected annual returns. This operates to keep annual compound (geometric) return at a more optimum level while reducing anxiety level.
But projected returns depend on the constancy of the correlations. Remember that this is a critical approximate assumption in the model, and models are never perfect. So constant monitoring is needed to respond to changes in the market’s interacting elements.
Incomplete modeling, evolving markets, and simply bad calculations are commonplace in the business world. I’m sure this observation surprises nobody.
Whenever I think about the imperfections of the investment universe, I’m somewhat comforted by reflecting on similar faults in the engineering world. Since I’m an engineer by both training and practice, I am qualified to recognize these deficiencies. Even in this scientific community, errors and mistakes in both design and execution happen all too frequently. So in one sense, I understand the problematic issues in the investment arena.
To illustrate, when I was at university, the professors repeatedly reminded us of infamous engineering failures. The 1907 Quebec Bridge and the 1940 Tacoma Narrows Bridge collapses were often emphasized. If you are not familiar with these disasters, here are two Links to short films that summarize these events:
Great stuff about Tacoma’s Galloping Gartie. Here is a short film that documents the series of Quebec failures:
The Quebec story has a particularly instructive sidebar. I’m told that the Canadian engineering establishment saved pieces of the failed construction. The story closure is that all graduating Canadian engineers are awarded a ring that has a small piece of the Quebec bridge imbedded in it. I don’t know if this story is true, but it’s emotional theatre.
It’s something to think about. Engineer’s are trained to keep hubris under control. That goes double for investment decisions.
If the engineering disciplines can generate such epic failures, it is not shocking that the undisciplined wild-west of the financial disciplines can also devolve into major calamities.
Best Wishes.
Regards,
Ted
Trust me, I have no issues admitting I made a mistake and move on. I just call bulls**t wherever I see it, GMO or AQR. Right now, GMO BS is a little more obvious to me.
Sorry, just saying...