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Please Let Bridgewater Explain How Risk Parity Really Works

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Please Let Bridgewater Explain How Risk Parity Really Works

In a letter recently sent to investors, Leon Cooperman of Omega Advisors said the latest market selloff and his poor August performance (his funds fell between 9 and 11 percent over the month) could not be fully attributed to the sluggishness in the Chinese economy and uncertainty surrounding a rate hike.

A CNBC article explains that Mr. Cooperman blames, among others, ‘"systemic/technical investors," which include "so-called risk parity funds and momentum investors known as CTAs. Initially commodity-focused, these commodity trading advisers' funds now invest across futures markets and are typically computer driven.”

“These investors, along with ‘smart beta’ passive equity strategies that have become increasingly popular, adjust their exposures according to algorithms in response to market moves, and spikes in volatility can trigger a rash of automated selling,” the article added.

Risk parity strategies have been blamed for the volatility seen in recent weeks. "There's not enough liquidity when all the elephants are trying to squeeze through the door," Eddie Perkin, Chief Equity Investment Officer at Eaton Vance told FT.

So, what is risk parity and how does it work?

Let Bridgewater, the largest hedge fund in the world and pioneer of this strategy, explain.

Risk Parity Is About Balance

In a report released within the past three years, Bob Prince, Co‑Chief Investment Officer of Bridgewater explained that risk parity is focused on balancing a portfolio’s risk exposures to achieve a greater chance of investment success compared to traditional, equity‑centric methods of asset allocation.

“The best way to achieve reliable balance is to design a portfolio based on a fundamental understanding of the environmental sensitivities inherent in the pricing structure of asset classes. This is the foundation of the All Weather approach,” he added.

The problem with traditional asset allocation strategies, he said, is that they tolerate higher short‑term risk “through a concentration of risk in equities in order to generate higher longer‑term returns.”

In his eyes, this approach has a big shortcoming. “If the source of short‑term risk is a heavy concentration in a single type of asset, this approach brings with it a significant risk of poor long‑term returns that threatens the ability to meet future obligations,” a form of risk that is clearly unnecessary.

The real zinger: “While a balanced portfolio will have short‑term risk, it can be neutralized to sustained shifts in the economic environment. This means that short‑term risks can cancel out over time, allowing an investor to more consistently achieve the higher long‑term returns that they desire," he concluded.

Posted-In: Bob Prince Bridgewater eaton vance Eddie Perkin Leon CoopermanAnalyst Color Education General Best of Benzinga

 

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