“Volatility,” says Ed Peters, partner and co-director of Global Macro at First Quadrant, “will be chronically low for awhile.” Yes, volatility responds to current events, such as the unfolding unrest in the Middle East, but it is broadly responsive to the business cycle, Peters notes, saying that we are in the part of the cycle that means low volatility.

From “2003 to 2006 there was low volatility,” Peters told AdvisorOne in New York on Feb 18. We had “high volatility from 2007 until mid-2010.” Now that volatility is low again, what does that mean for asset allocation? This topic came up because of a recent AdvisorOne Webinar, “Using Volatility as an Asset Class.” First Quadrant’s Director of Research, Paul Goldwhite, has written about this topic.

“We need strategies that build assets in rising markets and preserve them in declining markets,” advises Peters.

Peters uses “quantitative tools” tempered with qualitative factors to adjust First Quadrant’s investment strategies. “In low-volatility environments, you increase equities and reduce bonds to keep risk levels up; in high-volatility environments, you reduce equities to reduce risk levels,” he explains. The firm has $18 billion under management, “mostly for institutions,” and sub-advises mutual funds at Managers Investment Group.

Risk Parity—Balancing the Risk

For the past several years, Peters has been using a “risk parity strategy, balancing risks between stocks and bonds. It’s catching on now,” he says. For this strategy, he will “allocate according to risk, versus allocating according to capital.”

Long and Short

Peters has used a risk parity strategy since 2007 (when he was at a prior firm), and it’s been offered as one of the strategies at First Quadrant since 2009. For those who prefer to use mutual funds, the risk parity strategy is used in the first Quadrant sub-advised FQ Global Alternatives Fund, MGAIX (institutional class). This is a “global, tactical asset allocation fund” that makes long or short tactical allocations to equities, bonds and currency—allocating according to risk. The fund can use options, futures and forward contracts (derivatives) to make some of the allocations, and to get the desired risk exposures across asset classes, global geography and currencies. Balancing the risk equals “true diversification,” Peters emphasizes.

Long Only

One of the other mutual funds that First Quadrant sub-advises is the FQ Global Essentials Fund, MMAFX (institutional class), a “balanced, long-only” fund that invests tactically in stocks, bonds and commodities. This fund uses the “risk parity principles, balancing the risks between stocks and bonds,” says Peters.

Where do risk parity strategy funds belong in investors’ portfolios? “For a smaller investor, [Global Essentials, the long-only fund] is a good core strategy,” Peters explains, because it provides global allocation to stocks, bonds and commodities by risk instead of market cap. Investors, “just can't get greedy in a bull market—[it does] well in a bull market but won’t shoot the lights out.” Conversely, in a falling market, it is designed to preserve capital better than funds allocated by market cap instead of by risk. It has a “50% correlation, as opposed to most balanced funds,” which Peters says “have a 90% correlation with equities.”

First Quadrant also sub-advises the FQ Tax-Managed U.S. Equity Fund, an all-cap core tax managed fund, and FQ U.S. Equity Fund, an all-cap core equity fund, both at Managers Investment Group.