Fed, BOJ add shine to risk-parity strategy

Thu Sep 29, 2016 4:46am EDT
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By Richard Leong and Jennifer Ablan

NEW YORK (Reuters) - The Federal Reserve and Bank of Japan's actions last week have given a second wind to an alternative investment strategy that relies on cheap money and low market volatility to produce outsized returns.

Risk parity trades, which involve borrowing to take long positions in both stocks and bonds, have been favored by some big hedge funds and other institutional investors starved for yield by eight years of record low global interest rates.

The funds had a rough 2015 when volatility spiked because of concerns about China's economy and tumbling oil prices, prompting investors to yank more than $2 billion from risk parity portfolios, according to Morningstar. Since January, however, they have bounced back as volatility has fallen, delivering on balance returns more than twice as high as the mid-single-digit total returns from this year's sputtering U.S. equity and fixed-income markets.

For example, Bridgewater Associates, which pioneered risk parity investing two decades ago, has seen its $62 billion All Weather fund post a 13.1 percent return from January through end of August.

That rebound looked under threat, however, in the run-up to the Fed's Sept. 20-21 policy meeting when several policymakers seemed to suggest that a rate rise was in the cards and markets turned choppy.

Yet the Fed not only held fire, but also lowered its forecasts for future policy rates, effectively assuring investors that borrowing costs will stay low for longer. The BOJ, on its part, both affirmed its commitment to more asset purchases and made a new pledge to keep 10-year bond yields near current levels around zero.

The central banks' actions have stoked gains in stocks, junk bonds, emerging market debt and other risky assets that risk parity funds target. They also brought market measures of risks of big swings in the stock and bond markets to their lowest so far this year.

"So I would say if the Fed's latest move dampens cross-asset volatility, then leverage applied via risk parity funds should increase," Chintan Kotecha, senior equity derivatives strategist at Bank of America Merrill Lynch in New York.   Continued...

Men walk toward the Bank of Japan (BOJ) building in Tokyo, Japan, September 21, 2016.  REUTERS/Toru Hanai