Morningstar Advisor - April/May 2013 - (Page 44)

Spotlight Risk-Parity Funds A Risk-Parity Portfolio Fund Allocation (%) Hedge Scenario Expense Ratio (%) PIMCO Total Return BOND 40 Disinflation/Recession 0.55 iShares MSCI All Country World Min Vol ACWV 30 Disinflation/Growth 0.34 iShares Gold Trust IAU 10 Inflation/Mix 0.25 PIMCO Commodity Real Return PCRIX 10 Inflation/Growth 0.74 Cash 10 Inflation/Recession Total 100 these non-economic actors—again, provided you’re not paying a lot for it. 0.42 In other words, Commodity Real Return is a leveraged bet on inflation. The other major bet I make with my take on risk-parity is low-volatility equities. This twist has a two-fold advantage. — Leverage Edge First, it allows me to ramp up equities, which are undervalued to the hedge assets, without making the portfolio too reliant on economic growth. The second is that low-volatility equities have historically returned about as much as the broad market, but with—obviously— lower volatility. This return pattern has plausible economic reasons, meaning we can reasonably expect it to persist over the long run. (This so-called low-volatility anomaly deserves a discussion of its own, but we’ll leave that for another day.) The final change I make to the Permanent Portfolio is the use of an actively managed broad commodity mutual fund. While ETFs are near and dear to my heart, no commodity ETF right now is competitive with the best-of-breed, institutional-share-class mutual funds. PIMCO Commodity Real Return Strategy PCRIX uses swaps to gain exposure to the Dow Jones UBS Commodity Index with a small part of its assets and invests the rest in a strategy similar to the one pursued by PIMCO Real Return, which invests in inflationlinked and corporate bonds. 44 Morningstar Advisor April/May 2013 The ability to employ leverage is critical feature of risk-parity strategies. Indeed, leverage may be the reason why risk-parity should work. In an ideal world, where anyone can borrow at the risk-free rate with zero risk, Modern Portfolio Theory says that investors should invest in the best risk-adjusted portfolio and, if unsatisfied with the portfolio’s expected return, lever it up. Needless to say, the world is hardly ideal. Leverage is either outright banned by regulation or perceived as too scary and something to be avoided by many investors. It has its own risks. Many investors resort to concentrating their assets in equities and equity-like assets to achieve their return targets. We are observing such a shift today. Investors are shifting from cash to bonds to dividend stocks to boost their yields. The result of widespread leverage aversion is that low-volatility asset classes offer higher risk-adjusted returns, which can be exploited by investors willing to use leverage— that is, risk-parity investors. Several risk-parity mutual funds attempt to earn higher returns by applying leverage to balance the volatility contributions of a variety of asset classes, including commodities, corporate bonds, and currencies. The biggest “true” risk-parity funds are Invesco Balanced-Risk Allocation ABRIX and AQR Risk Parity AQRIX. Their institutional share classes charge reasonable but hardly bargain fees. The strategies, however, don’t necessarily hedge against inflation and growth risks in equal measure and at all times, meaning they can take active bets against a naïve risk-parity benchmark, so they deserve a closer look. Even if you don’t fully trust these newfangled risk-parity strategies, it’s still worthwhile to stress-test portfolios to see how sensitive they are to all four economic scenarios and perhaps to reconsider whether avoiding leverage is worth the cost. K Samuel Lee is editor of Morningstar ETFInvestor. A version of this article originally appeared in the June 2012 issue of Morningstar ETFInvestor. Note: In the table “Percent of Months in Each State, 1928-2012,” inflation is defined as year-over-year CPI growth above the 12-month moving average of year-over-year CPI growth; disinflation is when current year-over-year growth is below its 12-month moving average. Growth and recession are defined by the determination of the National Bureau of Economic Research’s Business Cycle Dating Committee.

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2013

Morningstar Advisor - April/May 2013
Contents
Contributors
Letter From the Editor
The Pursuit of Happiness and Financial Advice
What Strategies Do You Use to Control Risk?
Driven to Succeed for Clients and Family
How to Assess a Portfolio’s Bond Risk
Luck, Skill, and Investing
Investments á la Carte
Investment Briefs
Investing’s No- Brainers Have Costs
A Defensive Ride
Risk On/On Risk
The Risk of Being Overconfident
Year of Living Dangerously
The Risk-Parity Approach
A Guide to Mutual Funds Running Risk-Parity Strategies
What Moats Tell Us About Risk
Risk’s Wake-Up Call
Seeing Is Believing
Why Investors Lag the Returns of Their Funds
Liquidity Signals
Pump Them Up
Golden Oldies Keep on Truckin’
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Our Social Blind Spot

Morningstar Advisor - April/May 2013