The positive performance of risk parity products has been sneaking up on clients after poor returns in 2015. This long-only product have done much better than many other multi-asset hedge fund strategies in the last year with the HFR 12% vol institutional index being up 9.46% through September; however, it has been riding the wave of asset price mispricing or overvaluation.

Risk parity, in a very stripped down version divides the investment world into a simple set of asset classes which are given equal risk allocations. There are no return estimations or expectations so the portfolio can be considered a naive or no-information set of allocations solely based on volatility (or covariance depending on structure). It will compete against other macro approaches that have embedded expectations of relative performance. This naive approach has proved to be superior to more sophisticated approaches in the last two years. In simple terms, the forecasting skills of embedded in macro traders has underperformed the no forecasting skill of risk parity.

It makes sense to review a simple stylized model to describe what is going on. Let’s take four assets consisting of stocks, bonds credit, and commodities. Generally, stocks are more volatile than bonds, so a risk parity product will give more money to bonds over stocks. Credit and commodities are diversifying assets.

To understand recent performance, we have to look at the relative allocations when there is a change in volatility across asset classes. Assume first, that volatility declines. In this case, if the risk parity product has a fixed volatility target, there will be an increase in leverage to meet the target. The leverage effect in a falling vol higher returning environment is a significant positive. It has been a strong contributor to performance. If the volatility of equities has fallen relative to fixed income or other sectors, this will cause an increase in equity exposure in a rising return environment. Again this has been a positive effect.

The combination of higher returns in a lower volatility environment generates a positive leverage effect and a change in relative volatility with changing return patterns, specifically higher returns in lower volatility sectors has been a second strong effect. Volatility targeted managers may get a similar effect, but the drag may be forecasting skill.

If there is a reversal in market performance such that long-only will underperform as the markets move back to fair valuation, we should expect to see stronger global macro and managed futures performance. In the current environment, global macro managed futures may be a better choice if an investor believes mispricing risk will be reversed.