Risk Parity is Such a Drag

 

 

In this the last part of this series on the Permanente Portfolio, I can’t destroy David Ranson’s strategic design that utilizes the permanent portfolio concept as an investment vehicle. I said I would (jokingly), but you know, how can one harm this. Nonetheless, to make your visit worthwhile, allow your humble servant to address a dilemma facing the strategy of hedged investment with an all weather portfolio that uses risk parity (RP) to balance portfolio asset mix as originally conceived in the mid-nineties by the hedge fund manager Ray Dalio.

An investor who packed his funds into the trunk of the permanent portfolio investment vehicle over the past 45-years would have done well, and all the while, his transport avoided crackups, and driven smoothly along the reassuring right lane of investment bliss. Bridgewater Associates’ All Weather Portfolio accomplished such a journey since 1996 when its cultivated trip began. Using RP was innovative then, and according to David Ranson’s research, a fund that included RP to balance asset percentage allocation would have benefited during the 1969 – 1996 economic environment. From 1996 on, the all weather averaged over 9% a year, and RP helped imbue a confidence in Bridgewater fund managers that a future of 10% returns per annum along with low volatility could be confidently expected.

Putting any criticisms of a permanent portfolio and RP strategy aside (products of data mining, rear view mirror investing, straightjacketed investing, fortuitousness, etc.), the soundness of Dr. Ranson’s long-term all terrain vehicle rests on an empirically researched chassis of studiously reviewed evidence and results. Any investor or fund manager is welcome to spindle, mutilate, or total Ranson’s model, as well as consider it a Model T, a 69’ Detroit clunker, or a fine driving machine. One may also prefer to retrofit it to one’s pet algorithm or to one’s vision for the future, and there, the future, glistens from broken glass-covered asphalt. To paraphrase a battle weary warrior standing before the carcasses of future past: Now we are engaged in a great change in a decades-long cycle, testing whether that market, or any market so conceived and so dedicated to a long-term cycle, can long endure.

Today the eye in the storm of any all weather portfolio stares everyone in the face. Rates on long-term US bonds are almost certainly not going down further, declining as they have for over three decades, and their level as close to zero as practicable. Bonds, that mighty asset in David Ranson portfolio calls out for attention. The bond-wheel is flat from the nail driven into it by Federal Reserve monetary policy.

Non-predictive style investment is precisely what the all weather considers one of its positives. Don’t attempt to forecast the future, it advises. Nevertheless, with scales removed from investor eyes, it’s natural that they will refuse to ride on a flat. They will insist on anticipating where the economy and markets are with respect to the longest bull bond market in history, and consider the obvious soon to arrive inflection point on the interest rate cycle and what it suggests going forward. The dilemma is as simple as riding a bicycle, when interest rates rise, bonds immediately lose value, especially long-term fixed investment. Because among others, certain successful albeit imperfect seers of the past several decades are calling into question the future of bond market returns, a reconsideration of investment concepts vis-a-vis allocation to bonds seems prudent. What if we are standing at the cusp of a new interest cycle that slowly turns bonds into junk. And what does it do to the notion of risk parity. Can the risk issue that RP soothes in a bond bull market world, blow up a portfolio using RP to assign risk in a netherworld of increasing interest rates? Assign 50% of your funds to bonds and 50% to stocks, and you have 80% of your risk in stocks and 20% in bonds. Increase your allocation in bonds (Dalio does this by leveraging the bond allocation), and you achieve balanced risk, (along with, in this case, the traditional or institutional concept of diversification). RP would here demand an increase in bond allocation to achieve that balanced risk.

Not to take Barry Ritholtz at his word in his trenchant analysis of the All Weather Portfolio, or that the fund has had its challenging moments, or that the fund shrugged off something that its fundamental approach of steady investment was presumably not supposed to do, that is, tamper with the allocation percentage in a major sector, the fact remains about what to do in a world where investment in bonds appears to be a poor bet going forward. And how does one defend maintaining a substantial allocation in bonds and necessarily leverage that amount with borrowed money in order to achieve RP? With a swagger, smile, or stiff drinks.

It’s time for a video or a paper on the subject, and if the paper is unavailable, try When Risk Parity Goes Wrong, which really isn’t as ominous as the title suggests. My main point for the criticism of structuring RP into the portfolio, is to just bear in mind, “The authors warned investors that the last decade had been ‘unusually benign for treasuries, but in the coming decade as the Federal Reserve exits its quantitative easing program, this is likely to cause yields to gap higher to the detriment of levered fixed income portfolios.” Well, that tightening moment may begin by 2016, and even if one is not a world renowned investment guru, the POV of that change could see the beginning of a cyclical shift that grows to become a game changer. In that case, especially considering the issue of leveraged bond investment in order for a diversified all weather portfolio to achieve RP, the result could result in the unsustainability of RP for such a fund. To some, that could mean “screw RP,” thus forcing them to be unfaithful to their model, and send it to the junk heap, while they settle into a new supermodel consistent with the future. Expecting one to be a slave to bonds and RP could make one a slave to yesteryear’s realities unless respect for one’s tried and true model, like the sense of affection for one’s old trench coat, can be dissolved. Refusing to give up the cape that’s kept one warm and dry through thick and thin may cause one to not act freely, or if so, only when the water’s gotten through the frays in the lining. Economics is a fickle mistress that does not love one back.

But before we throw the wheel out with the tire, let’s consider the essentials of David Ranson’s permanent portfolio construct that are not in question and that HCWE’s research evidence shows to be fundamental to his smoothly running vehicle. The design is composed of four growth/inflation quadrants to cover every economic environment. Dr. Ranson’s work has identified the asset classes necessary to include in the matrix and in their appropriate quadrants as the economic environment dictates. The indicators for quadrant selection are the increased/decreased gold price and credit spread changes from the year before (current conditions whereby the price of gold is down and spreads are up from the year before, favor US bonds over other asset classes). The portfolio may be rebalanced annually or quarterly. However, in a Fed-tightening world, Ranson’s STAR portfolio design that allocates asset amounts to achieve RP may be called into question – at this point not by Ranson but by those who question the practicality of continuing to us RP going forward.

At issue is the wisdom of increasing bond allocation that will be necessary to achieve RP as bond prices fall, not to mention, the increased investment in a class that overall would continue to lose value. This is not an imminent threat for an existing portfolio of the kind under discussion, since Dr. Ranson expects the Fed target rate to increase at a snail’s pace that will mean interest rates will take many years to reach normal levels; however, a permanent portfolio being designed and fitted today would be wise to take the coming change seriously.

For the RP-confident, an outfit called Salient should provide hours of entertainment and potential usefulness. For those who wish to second-guess the permanent portfolio as devised with the inclusion of RP, that is to say, attempting to forecast economic conditions, they may wish to turn to common sense or any number of financial analytics and devise a realistic percentage of assets accorded each of the four economic categories.

For Bibles that come from God His very own bad self, adherence to the Word is required, otherwise pay in the next life for straying from His instruction. Other bibles maybe they ain’t so perfect, but who knows. My own opinion is to consider David Ranson’s design of the permanent portfolio and keep RP in abeyance. A layman’s potentially errant yet theoretically unvarnished common understanding of money, interest, bonds, and central bank monetary control may be sufficient to convince one to divide the asset pie in a more forward thinking approach that discounts the likelihood of an economic era’s change for bonds. The potential risk of avoiding loading up on bonds should be no more than the risk of continuing to divide the money pie amounts as directed by RP, and may likely be less. It’s my belief that the potentially positive long-term result of following HCWE’s permanent portfolio design liberated from RP is worth considering.

Next time, what Fed tightening will mean for interest rates, the economy, and investment, according to Dr. Ranson. Hint: chillax.

Art image: Ziggy Stardust

Tapering Like Brigitte Bardot’s Waistline

 

 

In a late March “barometric review” of the overall US fixed income picture, David Ranson’s Wainwright Economics finds it difficult to foresee any substantial change in the current yield curve. Under Janet Yellen, the Fed seems much more conscious of the poor state of the labor market despite the decline in the official unemployment rate. Tapering, Ranson says, will remain extremely gradual, this despite that “quantitative easing” inflates but does not stimulate.

According to Dr. Ranson, the evidence to support the Federal Reserve’s stimulation of the economy by easy monetary policy is unfavorable. Artificially low interest rates inhibit saving and lending, leaving borrowers no better off than before. What borrowing does take place tilts towards the well to do or the politically connected.

The Fed can print money and buy bonds, but it’s banks that generate money balances. The failure of money in circulation to grow is notorious in spite of enormous debt purchases in the course of the Fed’s quantitative easing initiatives. Wainwright’s analysis finds that the more money the Fed creates to buy up debt, the slower the economy grows.

Creating money is inflationary, especially when inflationary forces are expressed in terms of a market-driven sensitive indicator like the price of gold. In fact according to Wainwright’s findings, no matter which kind of hoped-for stimulus the government relies on, the effect is the same. The research concludes that true stimulus comes from the incentivization of private capital and not from turbo-charged government activity.

Luis de Agustin

Wainwright Economics

April 12, 2014

Monetarists Still Have It Wrong

 

 

It’s long ago since H.C. Wainwright in the 1970s revealed the faulty assumptions behind the monetarism of Milton Freidman. Nevertheless, the theory is again rearing its head in policy circles. Dr. Ranson was asked during a conference call to explain why it’s a failed concept. 

According to David, the basic tenet of Milton Friedman’s monetarism is that monetary policy is much more powerful than fiscal policy. He concurs. But in practice, monetarists tend to be characterized by two additional beliefs. One is that the link between the quantity of money in the economy and nominal GDP runs causally from money to GDP. The other is that money in circulation can be controlled by the central bank’s monetary policy. Friedman’s concept fails if either of these assumptions fails to be met.

As Ranson sees it, neither of the standard assumptions of monetarism is met. First, he thinks the link between the quantity of money and GDP runs causally from GDP to money. A stronger economy creates demand for credit and demand for money. In any case, velocity, the ratio between GDP and money, is variable. On the second point, he does not believe that the Fed can control the quantity of money for at least two reasons. The money multiplier is variable, and in any case, credit can be created elsewhere in the economy without the help of banks.

Luis de Agustin – Wainwright Economics

July 26, 2012

West Will Remain On Wrong End Of Capital Flow A Long Time

 

 

Wainwright finds, that with the currently tighter quality spreads, the short-term global growth outlook is better than at any time since the middle of the past decade. But the developing world has problems more complicated than is widely recognized. Officially the problem is inflation, and the central banks of developing countries are run by people who received their economics training in the West. For them, inflation is a threat to be countered by tight monetary policy. The upsurge in world inflation has therefore reduced official expectations of continuing economic growth. But Western-style economics is an unreliable guide at the best of times, for two major reasons.

First, tight monetary policy – even in the West – is no defense against inflation unless it is accompanied by a stronger currency. Interest rate hikes in India and China have been ineffective so far, and we expect they will not restrain inflation. Second, inflation in most of the developing world is not the threat it poses to economic stability in the US and Europe. Commodity-price inflation tends to boost the wealth that the emerging world possesses in the form of reserves of raw materials and minerals. Rising commodity prices also attract more capital at the expense of the West. The real threat to the developing world is the boom in world food prices, which is emphatically not a problem of supply or demand, but mainly the result of the dollar’s decline. Developing countries that are major food importers, especially if they have repressive regimes, are subject to what has happened already in Egypt and Libya, and there is a much wider threat of political upheaval as food prices continue to rise. So the continuing boom in the developing world will be much less uniform than before.

Dr. Ranson posits that Ben Bernanke’s recent forecast that the surge in commodity prices will be “transitory” merely shows how ignorant a well-trained economist can be. His and President Obama’s views are prime examples of George Orwell’s quip that “there are some ideas so wrong that only a very intelligent person could believe in them.” Although politicians are aware of the commonly recognized connection between currency weakness and commodity price inflation, they are in denial about the easily demonstrated link between both of these market phenomena and inflation generally.

The West, especially the United States, will remain on the other end of the capital flow for a long time to come. Suffering a net outflow of capital, it can no longer expect enough growth to reduce high unemployment. The US political stalemate over spending cuts and increased tax on the rich will keep the domestic economy in limbo at least until the next general election. This is going to be more and more politically unpopular, and the chances are that the Republicans will capture the White House and both houses of Congress in 2012.

Luis de Agustin – Wainwright Economics

May 12, 2011

Returns Of Equities In Terms Of The Dollar

 

 

Wainwright became bullish on gold (bearish on the dollar, really) in 2004, remained so and continues. The metal’s price is a major economic barometer for the firm. For most pros, the dollar-gold price is a fuddy duddy forecasting instrument akin to Grandpa’s arthritic knee, but to those who have listened, the bones have been very good indeed. Wainwright is the modern master of including this price as a principle and profitable analytical tool to explain past, current and expected monetary inflation.

According to a September 25 research study by the shop this year, the most recent rise in the price of gold is no surprise, as its upward trend has now been established for a decade. Over that period, the annual rate of increase has been nearly 17 percent. Scope continues to build for a large increase in oil prices.

And as the dollar falls relative to gold, so the return on equities expressed in terms of dollars, declines. That represents a twofold reduction in US real wealth. How much wealth has been lost by the dollar’s inconstancy? It won’t matter to those who measure successful investment by the Dow, S&P or other index number, but it’s a pull up your socks conclusion regardless.

BTW, there are no gold bugs at Wainwright Economics. The staff flees from the attribution. The case for investment in gold and more importantly its proper use in determining investment decisions has been long catalogued through meticulous research and empirically founded evidence by the research provider, and studies older than two-years are available gratis on its website.

Luis de Agustin – Wainwright Economics

October 13, 2010

Ranson Clearly Explains Falling Prices

Falling prices aren’t by themselves evidence of deflation anymore than rising prices necessarily signal inflation. Both are always monetary concepts that result from a rise or decline in the value of the unit of account.

Basic supply and demand when it comes to goods prices is not inflationary or deflationary. Change in the value of the currency is. Objectively against gold, the dollar is weak since 2001.

We’ve been inflating a long time. This correlates with economic weakness. When currency loses value, capital flows into hard, less productive assets, and away from creative and growth economy.

Luis de Agustin – Wainwright Economics

June 24, 2009