Our risk parity strategy seeks to help investors stay ready for virtually any type of economic environment by balancing its risks across stocks, bonds and commodities,1 which typically behave differently during different parts of the market cycle. Maintaining a diversified allocation may help prevent one underperforming asset class from dominating the returns of the entire portfolio. But what happens when stocks, bonds and commodities all fall together, diminishing risk parity’s diversification benefits? We came very close to experiencing this situation in August, so in this blog, I look at what investors could expect if risk parity’s “worst-case scenario” came to fruition.
August 2015: Markets just missed a triple negative
First, let’s review what exactly happened in the markets in August. During that month, stocks fell by 6.62%, commodities fell by 0.92% and bonds barely ticked higher with a 0.13% gain.2 With results like these, it’s not surprising for risk parity investors to wonder what would happen if all three asset classes fell in tandem.
How often have markets dropped together?
Now, let’s examine how often this type of scenario has occurred in the past. The chart below shows how often stocks, bonds and commodities were all negative and all positive from January 1973 to September 2015. Looking at the data on a monthly basis, all asset classes were negative 8.2% of the time — a relatively low figure. But as our time periods expanded to three months and then 12 months, the incidence of periods in which all three asset classes posted negative returns diminished dramatically.
When you look at the other side of the coin — periods when all three of the asset classes were up at the same time — you’ll see that these periods occurred at a much higher frequency than the “all negative” scenarios. And, the incidence of these “all positive” periods rose over time as well.
| Monthly | Rolling 3 months | Rolling 12 months | |
| % of periods that were all negative | 8.20 | 4.51 | 0.80 |
| % of periods that were all positive | 21.19 | 24.31 | 36.73 |
| Source: DataStream and Invesco analysis. Time period from 1/73 – 9/15. Stocks represented by the MSCI World Index, bonds represented by the Barclays U.S. Treasury Bellwethers 10 Year Index and commodities represented by the S&P GSCI Commodity Index. Past performance is not a guarantee of future results. An investment cannot be made directly in an index. | |||
Taking a long-term view
Why is this significant for investors? These trends illustrate the long-term benefits of diversification that risk parity strategies seek to capture. The Invesco Global Asset Allocation team believes that for long-term investors, all-negative months could present an attractive entry point for investing in risk parity strategies, given the underlying asset classes’ tendency to return to a state of “normal behavior” over time (i.e., at least one asset class posts positive returns, re-introducing the diversification benefits).
What’s to come? Uncertainty
Historical analysis always begs the question of what we expect to happen in the future. The problem, of course, is that no one knows exactly what’s going to happen — and when — as we move forward. Markets are dynamic systems that are very hard to predict. Because the future is inherently unknowable, we believe one of the ways investors can temper that uncertainty is by spreading their risk across asset classes that have historically behaved differently through the shifting phases of the economic cycle.
- Commodities have historically performed well in inflation-driven markets.3
- Stocks have outperformed in times of low inflationary growth.4
- Government bonds may provide a measure of defense against recessionary/deflationary periods.
While we can’t predict the future with certainty, history shows us that most of the time, one or more of these asset classes has delivered positive returns, especially over longer time frames. Invesco Balanced-Risk Allocation Fund incorporates all three asset classes at all times. We believe this may help investors stay prepared for what’s to come.
- Each asset class exposure — stocks, bonds and commodities1 — is built by considering the key drivers of return specific to that asset class.
- We combine these asset classes based on the amount of risk they may contribute to the portfolio. (Whereas other strategies, such as 60/40 portfolios, allocate a certain percent of capital to each asset class, regardless of their risk contribution.) We believe true diversification is key to limiting downside risk.
- Markets move in cycles, so the fund makes tactical adjustments to the portfolio, seeking to take advantage of these cycles, in an effort to make the portfolio more adaptive to the current environment.
To learn more about our team’s approach, read the previous blog, Risk parity: It’s about preparation, not predictions. You can also find more information on the fund page for Invesco Balanced-Risk Allocation Fund.
1 Under normal conditions, the strategy invests in derivatives and other financially-linked instruments whose performance is expected to correspond to US and international fixed income, equity and commodity markets. However, the performance of the asset classes cannot be guaranteed. The derivative investments and enhanced investment techniques (such as leverage) used by the portfolio are subject to greater risks than those associated with investing directly in securities or more traditional instruments.
2 Source: DataStream. Stocks represented by the MSCI World Index, bonds by the Barclays 10 Year Treasury Index and commodities by the S&P GSCI Commodity Index.
3 In the inflationary years of 1973 to 1981, commodities were the only asset class that provided meaningful returns above inflation. Commodities (S&P GSCI Index) returned 12.81%, inflation (Consumer Price Index) was 9.22%, T-Bills (Ibbotson U.S. 30-Day T-Bill Index) returned 8.23%, stocks (S&P 500 Index) returned 5.16%, corporate bonds (Ibbotson U.S. Long-Term Corporate Bond Index) returned 2.49% and long-term government bonds (Ibbotson U.S. Long-Term Government Bond Index) returned 2.49%. Sources: Morningstar; Bloomberg L.P., Lipper (commodities). ©2015 Morningstar Inc.; All rights reserved. The information contained herein is proprietary to Morningstar and/or its content providers. It may not be copied or distributed and is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.
4 Stocks were the clear leaders in the low-inflationary growth periods of 1942 to 1965 and 1982 to 1999. From 1942 to 1965, stocks (S&P 500 Index) returned 15.70%, inflation (Consumer Price Index) was 3.06%, corporate bonds (Ibbotson U.S. Long-Term Corporate Bond Index) returned 2.45%, long-term government bonds (Ibbotson U.S. Long-Term Government Bond Index) returned 2.11% and T-Bills (Ibbotson U.S. 30-Day T-Bill Index) returned 1.70%. (The commodities index S&P GSCI was not yet incepted.) From 1982 to 1999, stocks (S&P 500 Index) returned 18.52%, corporate bonds (Ibbotson U.S. Long-Term Corporate Bond Index) returned 12.17%, long-term government bonds (Ibbotson U.S. Long-Term Government Bond Index) returned 12.08%, commodities (S&P GSCI Index) returned 9.00%, T-Bills (Ibbotson U.S. 30-Day T-Bill Index) returned 6.23% and inflation (Consumer Price Index) was 3.29%. Sources: Morningstar; Bloomberg L.P., Lipper (commodities).
Important information
Past performance is no guarantee of future results.
Diversification does not guarantee a profit or eliminate the risk of loss.
The MSCI World Index is an unmanaged index considered representative of stocks of developed countries.
The Barclays U.S. Treasury Bellwethers 10 Year Index is an unmanaged index considered representative of US Treasury bonds with maturities of 10 years.
The S&P GSCI Index is an unmanaged world production-weighted index composed of the principal physical commodities that are the subject of active, liquid futures markets.
The S&P 500 Index is an unmanaged index considered representative of the US stock market.
The CPI is a measure of change in consumer prices as determined by the US Bureau of Labor Statistics.