Another Investing Fashion Hits the Wall


On the back of three consecutive days of decent gains, U.S. stocks are taking a breather this morning, with the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average down 0.6% and 0.79%, respectively, at 10:10 a.m. EDT.

"Risk-parity" funds get hit
More victims of the recent bout of volatility! The Wall Street Journal published a very interesting article on their website yesterday evening, according to which fashionable "risk parity" mutual funds have been hit hard recently.

Imported from the hedge fund world with a basis in modern portfolio theory, risk-parity funds invest across multiple asset classes (stocks, bonds, commodities, etc.) and aim to achieve the highest returns possible with a specific level of volatility (i.e., the best "risk-adjusted" returns). Typically, the fund's manager does this by resorting to leverage and/or by actively reallocating among the different asset classes, instead of maintaining a fixed allocation.

That sounds very clever and, as the article notes:

These type of funds have consistently outperformed traditional strategies since the financial crisis and have soared in popularity. Assets in risk-parity mutual funds totaled $15.1 billion at the end of May, up from $73.6 million at the end of 2008, according to fund-research firm Morningstar Inc. Some estimate there is as much as $200 billion in total in risk-parity assets.

However -- surprise! -- the funds have disappointed this year:

Risk-parity mutual funds have lost an average of 6.75% this year, according to Morningstar. Meantime, a stock-and-bond index comprising 60% of the S&P 500 stock index and 40% of the Barclays U.S. Aggregate Bond Index, a widely used bond benchmark, is up 6.76% this year, according to Morningstar. Risk-parity proponents often argue that their strategy is designed to beat a so-called 60/40 portfolio of stocks to bonds.

In the fund management industry, risk-parity funds are the equivalent of a new iPhone -- they allow the companies that offer them to charge investors higher fees. Over time, competitors enter the market with similar products, the fees come down, and it's time to come up with a new product. The trouble is that, unlike the technology industry, in which new products are (usually) demonstrably superior to previous models, that's not often the case with new products in the mutual fund business. In fact, I'd go so far as to argue that, in terms of the "technology," not much progress has been made since Vanguard first introduced its Vanguard Index Trust -- an S&P 500 index fund -- in 1975.

One of the main reasons for this is the aforementioned fees. If you pay a premium to upgrade your iPhone, it doesn't detract from its performance. However, every extra basis point you pay in fees to a mutual fund manager is coming out of the return you will ultimately earn. The net expense fee on AQR Funds' Risk Parity Fund is 1.04%, while the expense ratio on the Vanguard 500 Index Fund Admiral Shares is almost nearly a full percentage point lower at 0.05%. Perhaps the former is worth the difference -- but there is good reason to doubt it.

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