The Ultimate Guide To Risk Parity And Rising Interest Rates

Summary

• The Risk Parity strategy is built to endure any economic environment and free you from worrying about what might happen next.
• Rising interest rates are still a top concern for most investors.
• We examine how the strategy performed from the 1950s through the 1980s, and why it remains an excellent option even in worst-case scenarios.

Risk Parity has had a phenomenal year-to-date. One popular provider of the strategy for retail clients is up nearly 9% while the S&P is up a little over 3%. This is primarily due to big rallies in both the bond and commodity markets, as the Fed has continued to ease off on interest rates while the global outlook has stabilized.

YTD Performance of Major Asset Classes vs. Risk Parity (labeled "You")

Source: Yahoo Finance, Federal Reserve, WSJ, Hedgewise

Despite this strong outperformance, the bond rally has raised a familiar worry: what happens when interest rates rise? Given the strategy has a heavier bond allocation than most traditional portfolios, does it continue to be a viable option?

Fortunately, we have decades of historical data that show that rising interest rates are not a cause for great concern. In times of high inflationary pressure, like the 1970s, the strategy is protected by assets like commodities and inflation-protected bonds. While higher short-term rates do reduce the benefits of using leverage, our backtested model still performed at least as well as the S&P 500 throughout the 70s.

The absolute "worst case" scenario is one in which rates are being driven up by continuously strong real growth, such as the post-WWII economy from 1950 to 1970. In this situation, both bonds and real assets like gold will tend to perform poorly while the stock market rockets ahead. Though Risk Parity will probably underperform the S&P 500 over such a stretch, you will still make solid returns; they simply won't be as high compared to a portfolio of 100% equities.

In exchange for this possibility, you avoid the risk that the next 2008 may be right around the corner. While rising interest rates may seem like a foregone conclusion, recent history in Germany and Japan demonstrates that rates may

Analyst’s Disclosure:I am/we are long SPY, IEF, TIPS, GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. To the extent that any of the content published may be deemed to be investment advice or recommendations in connection with a particular security, such information is impersonal and not tailored to the investment needs of any specific person. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. This document is for informational purposes only. Investing involves risk, including the risk of loss. Information in this document has been compiled from data considered to be reliable, however, the information is unaudited and is not independently verified. Performance data is based on publicly available index or asset price information and does not represent a live portfolio except where otherwise explicitly noted. All dividend or coupon payments are included and assumed to be reinvested monthly.