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GMO's Ben Inker on Risk Parity Funds

edited July 2013 in Fund Discussions
Given the recent conversation about risk parity at MFO, I found this M* interview with GMO's Ben Inker pretty interesting. Sayeth Ben (emphasis added):


"The different risk parity implementations have different underlying assumptions behind them, but what a lot of them tend to assume is that the correlations between assets are going to be low. What the events of this spring showed is that's not always true, and what we think it's important for people to realize is what happened in May and June wasn't this weird, random event, meteorites striking the Earth in a way that's not (going to) happen again and could never be predicted. This is what you should expect to happen if cash rates normalize. It's not a guarantee that they will normalize, but it's a risk that's sitting there if you put together a portfolio and said, it's okay to lever this thing because the low correlations mean I'm going to be taking losses on one thing while I've got gains on another. That is absolutely not guaranteed to happen. You can rely on it less today given how low rates are than you could under normal circumstances.

"The other problem we see with risk parity is that it's assuming that risk premia exist rather than checking to see if they exist before investing. So the assumption was that even at a yield of 1.6% on the 10-year, that 10-year bonds offered a risk premium over cash, it was far from clear to us that at those levels they did. Now, maybe at a 2.5% yield they do or certainly at a 5% yield they would, but the two things we think you've really got to look out for, and that we think in various ways a lot of the managers of risk parity ignored, were, first and foremost, the correlations that they're assuming are going to be low are not always low, and we're in one of those situations where they could easily be higher in important and dangerous ways for an extended period of time.

"The second one is that just because an asset class has provided a return above cash historically does not mean it's priced to do that today. Levering up an overvalued asset class doesn't make it cheap. It is just a recipe for losing money."

He also has some interesting things to say about EM equities and debt; worth a full read, IMHO.

Comments

  • Thanks for the interesting read.
  • Good catch. Nice interview, GMO also wrote a paper on the dangers of risk parity a few years back.

    The Wall Street Ranter
  • edited July 2013
    Okay I didn't understand a word above. But I will go read article and re-evaluate WTF I bought AQRNX. It is 3% of my IRA.

    But here's my problem with "experts"

    Kinnel: Emerging markets are the brightest spot of your forecasts with a 7% real return forecast, which is interesting given that this year a lot of the news has been about a slowdown in China.

    Inker: Well, we have not actually been acting as if we believed that 7% forecast. That 7% forecast is assuming everything goes back to normal....


    OH REALLY? Furthermore...

    As a result, we have been more cautious on emerging markets than our forecast would suggest, and we still are...Emerging markets have some real problems, and we are trying to figure out exactly how they will play out.We still think you've got to own some, because they are pretty cheap even if they do have some problems.

    ...then it's not just that you get a bumpy ride, but you're not going to get the 7%. And that's what worries us more. We're perfectly happy to take a volatile 7%, and again we do own emerging markets and may well start buying some more over the next couple of months,


    So then WTF did you make the forecast? So others would buy first and you would buy when you felt it was time to time the market? So you can make the forecast, not really do what you say, but still say you were right all the same whenever it is convenient?
  • edited July 2013
    Reply to @VintageFreak: You and me both=). AQR has still not yet posted a 2Q commentary. Wonder why?

    image
  • Reply to @VintageFreak: Never own a fund that you don't understand, I'd sell ARQ Risk Parity.
    Regards,
    Ted
  • edited July 2013
    Reply to @Ted: What you probably meant to say is you would never have bought it in the first place. Vintage Freak made a comment about his wariness of experts (which I agree with) But at least Inker has a verifiable track record in his fund at GMO - GMWAX.

    http://quotes.morningstar.com/fund/gmwax/f?t=gmwax

    My question is what is the track record of all the *experts* who somehow have made the AQR risk parity funds groupthink MFO must have funds ????

    Edit: I should probably add that I am not targeting Charles here. These risk parity funds were groupthink funds here long before he came on board.
  • edited July 2013
    Reply to @Junkster: No problem. I'm still holding out some hope, but will post if and when I fold.
  • Reply to @Ted: I know, I know...no rubbing it in!
  • edited July 2013
    Reply to @Ted: You are absolutely right & thanks for noting this old adage. I'll submit, however, it's not always a black & white question. It's more of a "continuum" ... and most of us probably own one or more we don't fully understand. Of my funds, I'd list CVSIX and RPGAX in that category. The first because the approach continues to evolve with the evolving fixed income markets and also changes in management at Calamos. But, am happy overall with the performance and risk characteristics over the many years I've owned it. The second mainly because it's very new and I haven't seen any annual reports yet to learn & digest WTF they're doing with it. In this case my faith in the sponsoring house led to placing a small bet on a rather new and unique approach (investing a small fraction in hedge funds).
  • Reply to @Charles: Charles, I actually hope it works out well for you and proves all the naysayers (myself included) dead wrong. You are a hard guy to dislike.
  • MJG
    edited July 2013
    Hi Guys,

    Correlation coefficients are not static entities. They may have nice long-term statistical averages, but they are dynamic over shorter timeframes. It’s like the story of a man drowning while attempting to cross a stream with an average depth of a modest 2 feet. The tragedy was caused by the unknown dangerous water depth at mid-stream.

    Any investment strategy that is based on an invariant correlation coefficient is exposing itself to substantial hurt and perhaps even risking ruin. The historical database clearly demonstrates the dynamic correlation relationships between individual holdings and categories of the marketplace. Correlations are compliant subjects of both group and individual market perceptions. The interactions are complex and defy characterization.

    Regardless of what correlation coefficient values exist in a placid trading environment where prices move slowly as a function of modest supply/demand imbalances, these same correlations accelerate towards a perfect One level as bubbles approach their critical bursting point. The 2008 equity meltdown serves as an excellent illustration of this phenomena; there was literally no place to hide.

    Correlation differences among candidate holdings are a great tool to help designing a diversified portfolio to reduce overall portfolio risk by attenuating its volatility (standard deviation) while sustaining projected annual returns. This operates to keep annual compound (geometric) return at a more optimum level while reducing anxiety level.

    But projected returns depend on the constancy of the correlations. Remember that this is a critical approximate assumption in the model, and models are never perfect. So constant monitoring is needed to respond to changes in the market’s interacting elements.

    Incomplete modeling, evolving markets, and simply bad calculations are commonplace in the business world. I’m sure this observation surprises nobody.

    Whenever I think about the imperfections of the investment universe, I’m somewhat comforted by reflecting on similar faults in the engineering world. Since I’m an engineer by both training and practice, I am qualified to recognize these deficiencies. Even in this scientific community, errors and mistakes in both design and execution happen all too frequently. So in one sense, I understand the problematic issues in the investment arena.

    To illustrate, when I was at university, the professors repeatedly reminded us of infamous engineering failures. The 1907 Quebec Bridge and the 1940 Tacoma Narrows Bridge collapses were often emphasized. If you are not familiar with these disasters, here are two Links to short films that summarize these events:



    Great stuff about Tacoma’s Galloping Gartie. Here is a short film that documents the series of Quebec failures:



    The Quebec story has a particularly instructive sidebar. I’m told that the Canadian engineering establishment saved pieces of the failed construction. The story closure is that all graduating Canadian engineers are awarded a ring that has a small piece of the Quebec bridge imbedded in it. I don’t know if this story is true, but it’s emotional theatre.

    It’s something to think about. Engineer’s are trained to keep hubris under control. That goes double for investment decisions.

    If the engineering disciplines can generate such epic failures, it is not shocking that the undisciplined wild-west of the financial disciplines can also devolve into major calamities.

    Best Wishes.
  • Reply to @MJG: Translated into English ! AQR Risk Parity Funds are Turkey's! ?
    Regards,
    Ted
  • Reply to @Ted: Too much...first time I've laughed all day.
  • Reply to @VintageFreak: As he says in the interview, they do the 7 yr. forecasts according to a standard methodology ... and so he's being honest with us by saying he's not sure the standard methodology captures everything that's churning in the EM world.
  • Reply to @Ted: Okay I thought I understood AQRNX. I'm willing to re-examine my assessment. What I said I didn't understand was the excerpt from the GMO article that started this thread.

    Trust me, I have no issues admitting I made a mistake and move on. I just call bulls**t wherever I see it, GMO or AQR. Right now, GMO BS is a little more obvious to me.
  • edited July 2013
    Reply to @Ted: Forgive me Ted. You seem to0 smart to simply show performance numbers when deciding for/against a fund. "reporting periods" change monthly. Lately you seem to be making this the end all and be all.

    Sorry, just saying...
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