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Risk Parity strategies have been effective and popular strategies since the early 1990s as diversification benefits enabled risk parity strategies to make money in most environments. However, the tide may be going out for risk parity strategies as rising interest rate environments impact their ability to use leverage to boost returns.

While investors wonder if this is the ebb of risk parity strategies, the number of alternative mutual funds and ETF/ETNs continues to rise. This raises the following question. If both risk parity and alternative funds provide diversification and downside protection, can allocation to alternative funds provide risk parity like returns? In other words, are alternative funds the new risk parity strategies?

*Risk Parity portfolio consists of 8.8% MSCI USA Small Cap, 10.7% MSCI USA, 10.6% MSCI USA Value, 10.8% MSCI USA Growth, and 59.1% Fixed Income (CITI 10+ Govt Bond Index). Market Portfolio is 60% Equity MSCI USA IMI and 40% Fixed Income. Sharpe Ratios 85 - 2011. Source 2013 MSCI Barra

Historically, as shown by the MSCI Barra graph above, risk parity strategies have weathered market downturns and delivered returns above a standard 60% equity/40% bond market portfolio. However, as interest rates have risen starting in 2Q2013, risk parity strategies have been hit hard. The graph below shows two risk parity strategies, one managed by AQR and the second managed by Invesco. Both funds have taken significant hits since May 2013 with the funds down 6.45% and 3.21% YTD respectively.

Bootstrap comparison: Risk Parity vs. Alternative+ Portfolio

The graph below shows growth of a $1 invested since March 2004 for a passive, non-levered risk parity portfolio as compared with a 60% equity/40% bond market portfolio. As expected, the risk-parity portfolio lowers downside risk via diversification and maintains a greater return until 2Q2013. The market portfolio closes the gap and then overtakes the risk parity portfolio only due to the extended bull market from 3Q2012 to 1Q2013.

*Risk Parity portfolio consists of 8.8% Ticker: VB, 10.7% Ticker: SPY, 10.6% Ticker: IWD, 10.8% Ticker: IWF, and 59.1% Ticker: AGG. Market Portfolio is 60% Ticker: SPY and 40% Ticker: AGG

As the growth comparison is based on a passive, non-levered risk parity strategy, a chart of AQR's Risk Parity strategy is also included as AQR uses both leverage and active management. The inception of this mutual fund is in 2010 so the chart is from October 2010 until August 20, 2013. The reversal in May 2013 markedly stands out in this graph.

Investment in alternative funds that provide absolute and low correlation to equity returns should also provide downside protection and a risk/return structure similar to risk parity strategies. Alternative funds and ETFs have become increasingly popular as a method to provide hedge fund like returns without the 2/20 administrative costs of hedge funds. Many of these funds started trading post-crisis and therefore don't have a long track record. However, indices such as Hedge Fund Research's Global Hedge Fund Index (HFRX) may provide a proxy measure for aggregate level performance.

For purposes of this research, two alternative funds were chosen. The first is the Natixis ASG Global Alternatives Fund (Ticker: GAFYX). The second is Goldman Sachs Absolute Return Tracker Fund (Ticker: GARTX). GAFYX is an absolute return fund that seeks to provide capital appreciation consistent with a portfolio of hedge funds. Similarly, GARTX also seeks to provide returns consistent with investment in a basket of hedge funds. Both GAFYX and GARTX began trading in 2008.

Two alternative portfolios were created. Alternative portfolio1 has a 40% allocation to Fixed Income (NYSEARCA:AGG), 40% allocation to equities (NYSEARCA:SPY), and 20% to the alternatives fund (GARTX). Alternative portfolio2 has a 40% allocation to Fixed Income, 40% allocation to equities, and 20% to the alternatives fund (GAFYX). A 20% allocation to alternatives came through reduction of the 60% equity allocation in the market portfolio. The basis of only decreasing the equity allocation is that, historically, returns from a basket of hedge funds have a higher correlation with equities than bonds. Likewise, a basket of hedge funds also should provide downside protection when applied to equity investments.

Interestingly, correlation of the AQR fund (MUTF:AQRIX) to GARTX and GAFYX are much lower (0.22, 0.38) which points to the effect of active management of a risk parity strategy. The $1Growth charts shows how closely a passive risk parity and alternative portfolio have moved together since 2010.

Does this prove that alternative+ portfolios are the new risk parity strategies?

No. However, this does infer that alternative portfolios can provide passive risk parity like returns. Alternative portfolios should also provide downside protection as well.

In the last five years, a number of alternative ETFs have been created. These ETFs include a variety of hedge-fund basket and replication ETFs, including Index IQ's IQ Hedge Multi-Strategy Tracker ETF (TICKER: QAI) and ProShares Hedge Replication ETF (TICKER: HDG). In theory, allocation to these ETF hedge basket tools will provide diversification and passive risk-parity like returns. Absolute and Market Neutral Funds like Credit Suisse Merger Arbi Liquid Index ETN (TICKER: CSMA) and State Street's SPDR SSgA Multi-Asset Real Return ETF (TICKER: RLY) should also be considered. These new classes of alternative ETNs and ETFs open up the alternative across the retail investment space.

Source: Are Alternative Portfolios The New Risk-Parity Strategy?