Sailors and mountaineers know it: weather can
\nvary all of a sudden and change a nice family
\njourney into a dangerous endeavour. 2015
\nstarted like a beautiful year, blessed by as many
\nas fourteen central banks\u2019 simultaneous efforts
\nto support the economy, with the BoJ and ECB
\nat the forefront. The family picture on 31 March
\nwas great: equities and bonds were up during
\nthe first quarter; European equities were finally
\ncatching up with US equities (up 22%), while
\nAsian stocks were also posting double digit
\ngains, led by China and Japan.<\/p>\n
Then, storm clouds gathered. Having bottomed out
\nat 7 bps on 20 April, the 10-year bund yield soared
\nunexpectedly to 98 bps in just a month and a half,
\ngenerating an unprecedented loss in value of 8.3%. As
\nsoon as bond markets stabilised, the Grexit drama came
\nback to haunt investors and policymakers. These clouds
\ndissipated eventually after another marathon all-night
\nsummit. But this was a short term relief. Concerns over
\nChina\u2019s foreign exchange regime and uncertainties over
\nthe Fed\u2019s stance caused unprecedented movements in
\nequity markets in August. Over five trading sessions,
\nbetween 17 and 24 August, the S&P 500 suffered a 10%
\ndrawdown. Digging into the data since 1928 it appears
\nthat the probability of such double-digit movements on
\na weekly basis is below 0.5%. Over the past 50 years,
\nthis has only happened on five occasions: October 1987,
\nApril 2000, September 2001, October 2008 and
\nAugust 2015.<\/p>\n
The market movement was not limited to stocks.
\nCommodities and emerging market currencies were
\nunder pressure but overall, the damage was far more
\npronounced on equities. The Volatility Index (VIX) jumped
\nfrom 13% on 17 August to 41% at market close on
\n24 August. Such a 200% rise in volatility on a weekly
\nbasis has not been observed over the last 25 years, i.e.
\nas far back as our data goes (1990). During the global
\nfinancial crisis and subsequently during the eurozone
\nsovereign crisis, implied volatility as measured by the
\nVIX reached extreme levels but the jump was much <\/p>\n
more gradual. The extent of the movement in implied DESPITE MARKET WORRIES, GLOBAL GROWTH There are fundamental weaknesses that justify market That said, it seems to us that in the medium term, the Overall, the world economy is likely to be supported STAY INVESTED INTO HEDGE FUNDS AND RISK It is precisely because there are bad times that there Aside from this Market Premia harvesting, diversified Hedge Fund Hedge Fund strategies have proven very resilient this The short term case for risk budgeting strategies is more Certainly risk budgeting strategies can lead the manager As the VIX soared brutally from 13% on 17 August As an example, between 17 August and 24 August, THE RISK PARITY, MARKET, AND 60\/40 PORTFOLIOS: As far as their performance are concerned, riskbudgeting On top of that, the remarkable long-term properties of Interestingly, these simulations show that not only risk parity Even if not doing it in a systematic manner, we definitely![\"budgetez_vos_risques.jpg\"](\"http:\/\/www.next-finance.net\/http:\/\/beta.next-finance.net\/wp-content\/uploads\/2015\/10\/budgetez_vos_risques.jpg\")
<\/a><\/p>\n
\nvolatility registered in August 2015 was basically beyond
\nwhat we experienced in the wake of the Lehman fallout.<\/p>\n
\nSHOULD MAINTAIN ITSELF<\/strong><\/p>\n
\njitters. The economic recovery in Europe and in Japan is
\nweak, large emerging markets ranging from Brazil to China
\nand Russia are experiencing a severe growth deceleration
\nand deflation risks remain significant across the board.
\nMeanwhile, the Federal Reserve will sooner or later have
\nto reverse an unprecedented accommodative stance.
\nThe valuation of US equities signals that they are now
\nhistorically expensive, whether measured by the price-tobook
\nratio or by the cyclically adjusted price-earnings ratio.<\/p>\n
\npositive developments on the US recovery front will
\noutweigh the negative implications of the above. Private
\nconsumption, which has been robust lately, will continue
\nto receive support from lower oil prices, despite the fact
\nthat they will depress capex from commodity sectors.
\nRecent data suggested that the US economy grew 3.7%
\nin the second quarter of 2015, fuelled in particular by
\nprivate consumption which contributed 2.1 percentage
\npoints. Meanwhile, the US labour market is vibrant, with
\nunemployment in August having reached 5.1%, a level
\nthat seems out of reach to many European countries.
\nFinally, the real estate market is also upbeat, with existing
\nhome sales reaching their pre-recession pace recently
\n(5.6 million units in July).<\/p>\n
\nby buoyant growth conditions in the United States.
\nHowever, the sharp growth deceleration in emerging
\nmarkets implies that aggregate demand will likely remain
\ndepressed. In this environment we continue to prefer
\nEuropean and Japanese equities. Their valuation remains
\nattractive in relative terms and earnings momentum has
\nrecently been supportive. For the reasons listed above
\nwe maintain a neutral stance on fixed income: a low
\ngrowth environment and deflation fears are supportive
\nbut valuations are expensive.<\/p>\n
\nBUDGETING STRATEGIES<\/strong><\/p>\n
\nis a long-term premium in investing into markets. If our
\nscenario is correct, markets will keep on conveying the
\nvalue generated by the growth of the global economy,
\npossibly in a perturbed manner.<\/p>\nMore than ever we believe that combining risk-budgeting
\nand alpha strategies delivers returns in the long run. Riskbudgeting
\ngenerates sound risk-adjusted returns.<\/quote> <\/p>\n
\nportfolios contribute to smoothing the ride. Let us review why.<\/p>\n
\nyear. Event Driven\/ Risk arbitrage have suffered but most
\nEquity L\/S or Global Macro managers have managed
\nto smoothen the global turmoil. As of end-September,
\nthe Lyxor L\/S Equity Broad index is up 1% year to date,
\nwhile global equity indices are down almost 10%. The
\nHFR Fund of Fund was still positive end of August
\neven if September moves will likely bring it in negative
\nterritories. At that date, some Funds of Hedge Funds
\nwere displaying positive performances, some of them
\nabove 2%, which is quite remarkable in this environment.
\nAlpha strategies have been under pressure over the 6-year
\nmarket rally. But over the course of 2015, investors have
\nincreasingly allocated to such funds due to traditional longonly
\nfunds being less attractive in relative terms. Interestingly,
\ninflows into liquid alternatives in 2015 are reaching record
\nlevels in Europe, at EUR 50bn between January-August
\n2015. This confirms, if any proof was needed, the long-term
\nhedging properties of Hedge Funds as long as investors put
\nenough emphasis on due diligence matters.<\/p>\n
\ninvolved. They have been roasted by some commentators
\nrecently for two reasons: 1) they have contributed to
\ndownward market movements; 2) they have posted
\ndisappointing performances. Not only risk budgeting
\nhas been wrongly charged of exacerbating market
\nmovements but we point out the remarkable long-term
\nproperties of these strategies.<\/p>\n
\nto sell despite having a positive outlook on the market.
\nBut this is like reducing the sail surface of a boat when
\nthe wind picks up. It might prove costly if the wind falls
\nback but might also avoid a very difficult situation if the
\nwind picks up again.<\/p>\n
\nto 41% on 24 August, some people judged that risk
\nbudgeting strategies would have immediately cut their
\nposition in the same proportion (by 3) hence worsening
\nthe sell-off. In our view, this is very much exaggerated.<\/p>\nFirst, the worst of the sell-off happened in China
\nwhere, to the best of our knowledge, the risk-budgeting
\ninvestment style simply does not exist. Second, if most
\nrisk-budgeting managers indeed use volatility as a proxy
\nfor risk, they typically use a 3M to 1Y historical volatility
\nand not the VIX.<\/quote><\/p>\n
\n6-month volatility of the S&P 500 has moved from
\n11% to 16% which, while significant, is of a reasonable
\nmagnitude. On top of that, the proportion of investors
\ninvesting with a risk budgeting approach is likely to be
\nlow as compared to the value oriented approach, which
\ntends to increase positions when the market falls.<\/p>\n
\nCUMULATIVE RETURNS, 1926-2010[[Notes: This figure shows total cumulative returns (log scale) of portfolios
\nof U.S. stocks and bonds in our long sample. The value-weighted
\nportfolio is a market portfolio weighted by total market capitalization and
\nis rebalanced monthly to maintain value weights. The 60\/40 portfolio
\nallocates 60 percent to stocks and 40 percent to bonds and is rebalanced
\nmonthly to maintain constant weights. The risk parity portfolio targets an
\nequal risk allocation across the available instruments and is constructed
\nas follows: At the end of each calendar month, we set the portfolio weight
\nin each asset class equal to the inverse of its volatility, estimated by using
\nthree-year monthly excess returns up to month t \u2013 1, and these weights
\nare multiplied by a constant to match the ex post realized volatility of the
\nvalue-weighted benchmark.]]\n<\/a><\/p>\n
\nstrategies cannot escape the global market
\nsell-off, particularly when they are long-only. This said,
\nmost of them deliver returns above traditional balanced
\nfunds since they have reduced gradually their exposure
\nas long as market risk was increasing.<\/p>\n
\nrisk budgeting should be kept in mind. AQR Asness,
\nFrazzini and Pedersen (2012) published a very long-term
\nsimulation of a typical risk parity strategy in a article in the
\nFinancial Analyst Journal[[Asness C., A. Frazzini and L.H. Pedersen (2012), \u201cLeverage Aversion and
\nRisk Parity\u201d, Financial Analysts Journal Vol. 68 (1).]].<\/p>\n
\nstrategies do extremely well since 1980 but they would
\nhave also been quite resilient between 1930 and 1980.
\nSimilar results can be found in many textbooks such as the
\nauthority on the matter published by T.\u00a0Roncalli in 2013[[See Roncalli T. (2013), \u201cIntroduction to Risk Parity and Budgeting\u201d,
\nChapman & Hall\/ CRC Mathematics Series.]].<\/p>\n
\nrecommend thinking in terms of risk allocation more than
\nin terms of dollar allocation since this has proven to be
\nand will likely remain much more efficient. <\/a>\n\t\t\t<\/div><\/figure>