Ben Treece: Haven’t learned the hard wayWritten by Ben Treece | | firstname.lastname@example.org
2008 was a year for the history books in the economic world. Not since the ’70s had we seen such a sharp drop in equities in such a short amount of time. Losses were not contained to the equities sector, or even to this country. Europe saw substantial losses as well, and the real estate industry is still recovering, slowly but surely, from that time. Highly leveraged investors and risky derivatives were the source of this market catastrophe, so surely we as investors would be smart enough to avoid them in the future.
Flash forward to 2013, hedge fund and money managers are at it again, this time in the bond market. According to The Wall Street Journal, more and more managers are engaging in the “risk parity strategy.” The traditional portfolio, as described by most finance professors, consists of 60 percent stocks and 40 percent bonds, but when looking at the risk of the entire portfolio, the 60 percent stock portion carries 90 percent of the risk of the whole portfolio. This investment style aims to spread the risk around to various instruments, such as commodities or futures.
It’s marketable strategy, but a dangerous one as well. The article notes that in Fairfax, Va., the Fairfax County Employees’ Retirement System has a 90 percent exposure to bonds when calculating in their leverage. As I have mentioned in several of my articles, the bond market is an incredibly dangerous place at this point in time.
Bond prices and interest rates vary inversely, so if interest rates are low, bond prices are high, and vice versa. With rates at historic lows, bond prices can really only go one way.
Many investors will read that and say “No problem, when it turns down I will sell it off and be done with it.” That is just the type of dangerous thinking that will leave many market participants flat broke. Who exactly would you sell to, theoretically? Realize that if long-term federal debt goes from 3 percent to 6 percent interest, the value of the bond has been slashed in half. Who would possibly want to buy in that type of environment? Furthermore, when prices fall, they do not decline gradually, they plummet quickly.
Many risk parity proponents have been singing a different tune when it comes to marketing their strategy. “We’re not as leveraged as Wall Street was back in 2008,” and “We have ample liquidity” are both commonly heard defensive positions for those selling the strategy. It is all smoke and mirrors.
Risk parity has only been around commercially since 2001 and has not truly stood the test of time. In that time, bond prices have done nothing but go up, and the theory has yet to prove that it can achieve substantial gains when interest rates begin to rise.
Another one of the fundamentals of this theory is that when stock prices fall, bond prices rise and the investor wins. The Dow Jones recently surpassed a five-year high; does that sound like a good sign for bond exposure? Ray Dalio, president of Bridgewater Associates, said that if bond prices go down, equity gains should offset losses in risk parity portfolios. Let’s assume that same scenario of 3 percent interest rates rising to 6 percent and your portfolio is half debt exposure, half equities exposure; by Dalio’s theory, the Dow Jones would have to rise to well over 27,000 in order to counteract bond losses. Quite a far-fetched proposition to say the least. Dalio’s assertions sound very much like those of managers who used the modern portfolio theory of the ’80s, which resulted in substantial losses for investors in the crash of 1987.
Use common sense and do not be sold on highly leveraged and risky investment strategies. If it sounds too good to be true, it is. If someone tells you that their strategy is immune to losses, run like hell.
Ben Treece is a 2009 Graduate from the University of Miami (FL), BBA International Finance and Marketing. He is a partner with Treece Investment Advisory Corp (www.TreeceInvestments.com) and a stockbroker licensed with FINRA, working for Treece Financial Services Corp. The above information is the express opinion of Ben Treece and should not be construed as investment advice or used without outside verification.