Risk-parity funds are tracked by Morningstar

Most investors prefer less volatility to more. But they might overlook how the components of their asset allocation contribute to portfolio’s volatility.

Lee Partridge, chief investment officer of Salient Partners in Houston says the usual 60/40 blend of equities and fixed income is an example of dollar weighting not matching that of volatility. With this allocation, stocks account for about 95% of the risk contribution, he says, simply because equities are much more volatile than stocks.

Risk parity (or RP) funds address that imbalance, he and other experts say.

Instead of viewing portfolios solely on their dollar-based allocation, he explains, RP looks at them “through the lens of risk-based allocations.”

An RP-approach attempts to have an equal contribution to returns’ standard deviation come from different assets, which generally are stocks, bonds and commodities.

RP is more than just a passive diversification strategy, he says: “It’s not just to get asset class exposure more broadly; it’s to defend against a broader range of economic scenarios.”

Stocks do well in a “positive-growth, benign-inflation state of the world,” Partrige adds. “They don’t do as well when inflation gets out of control or when you get a serious bout with economic contraction. That’s why one would have a higher or a more equally weighted risk allocation to commodities and bonds, because they do well during periods of runaway inflation or during periods of contraction respectively.”

In theory, RP-funds can provide a higher return for a given level of risk or produce lower risk for a targeted expected return.

Hedge funds, like Bridgewater Associates’ All Weather product, initially offered the strategy.

But there’s no guarantee that strategy will work all the time, of course. In 2013, mutual funds using this approach turned in poor performances.

The S&P 500 is not an appropriate benchmark for them, so a blended stock-bond index is often used for comparisons. Morningstar reports that the six RP-mutual funds that it tracked over the year had total returns ranging from -6.16% to 3.74%, significantly trailing the 60/40 MSCI World/Barclays Capital Aggregate benchmark’s 14.8% return.

Among the three RP-funds with a 3-year history as of Dec. 31, 2013, two of the funds had higher standard deviations than the blended benchmark.

Despite last year’s weak performance, RP-funds still make sense, Partridge says.

RP-funds take a disciplined approach to meeting their risk targets; consequently, their portfolios’ allocations evolve as risk parameters in the environment change. The Salient Risk Parity Fund’s (SRPAX) 2014 performance through June 30 supports that contention. It produced a 13.45% year-to-date return (7.19% after maximum sales charge), outperforming the 60/40 blended index’s 5.33% performance.

Other RP-funds also have produced year-to-date gains in 2014.

RP-funds can serve several roles in investors’ portfolios, he maintains.

The strategy provides diversification as a result of its low correlation to stocks, bonds and commodities.

Another approach is to use the funds as a core holding.

This makes sense given Salient’s belief that traditional asset classes’ returns over the next 10 years will not be very impressive.

“(You) can start thinking in terms of risk-based allocation models as opposed to dollar-based allocation models and then treat this kind of adaptive, evolving structure as being the core of a portfolio allocation,” explained Partridge.

“There are some large pension plans and sovereign wealth funds that are doing just that,” he added. “They tend to be at the more sophisticated end of the scale. We haven’t really seen the retail community adopted in as complete a fashion as some of these larger, more sophisticated institutional investors have.”