Salient to Investors:

The decline at Bridgewater Associates’ All Weather fund and similar funds shows allocating assets between stocks and bonds can leave investors overexposed to rising interest rates.

Ramin Nakisa at UBS Investment Bank said June’s sell-off in Treasuries and inflation-linked bonds was just a dress rehearsal for the volatility awaiting when QE tapering begins.

Larry Swartz at Fairfax County Retirement Systems said stocks really depend on increasing expectations of growth.

Ben Inker at Grantham, Mayo, Van Otterloo contended that risk parity owes much of its success to the tailwinds of a 30-yr bond market rally, because the funds invest a large portion of their assets in debt and related instruments. Inker in March 2010 said the beguiling combination of lower risk and higher return that the risk-parity strategy appears to offer is largely an illusion.

Thomas Lee at Clifton Group said excessive interest-rate risk has been the chief complaint thrown at every risk-parity strategy for years and years.

Robert Prince at Bridgewater said rising interest rates generally stem from accelerating economic growth or increased inflation, environments in which bond losses could be offset by profits on commodities and stocks. Price said the exception to this scenario would be a small subset of cases such as an extreme Fed tightening of liquidity or an implosion of the financial system in which all asset prices decline, and whose impact would be short-lived.

John Brynjolfsson at Armored Wolf  said Bernanke’s words in June were radical, and implied he would be comfortable with inflation being below target rather than keeping his foot on the gas pedal until inflation exceeded the target.

Eric Sorensen at PanAgora Asset Mgmt said judging duration for equities is messier than for bonds because a stock’s duration is also influenced by the type of company being examined and the reason rates are changing. He said that when inflation pushes rates up, bonds generally decline while stocks, particularly cyclical companies, fare well, allowing a risk-parity fund to offset fixed-income losses with equity gains.

Sorensen said stocks and bonds have both fallen in response to rising rates several times during the past twenty years: e.g. in early 1994, and the time to hedge that kind of risk is not when the risk is upon you – if you had been hedging throughout for the potential of stocks and bonds to have a high correlation to rate movements, you would not have made as much money.

Woody Jay at CRT Capital said the most popular trade of the last year has been on the back of QE, that it has to drive up inflation at some point – the trade was so one-sided, it was not surprising that TIPS were overdone in the sell-off.

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