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updated: 6/2/2013 6:49 AM

Risk-parity funds, the next 'better mousetrap'?

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Associated Press

The mutual fund industry is forever trying to build a better mousetrap--with mixed results.

Index funds were once a novelty, but pioneers like Vanguard 500 brought about a new standard for low costs, tax efficiency and solid performance. Target-date funds, too, were once the next big thing, but losses as high as 45 percent during the 2008 crash gave the category a black eye.

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The latest contender to be a better mousetrap is known as the risk-parity fund. Just four years after their debut, the new breed of funds has already attracted nearly $30 billion in assets--$16 billion of that in the past year alone, according to Lipper.

Risk-parity funds are designed to navigate changing economic conditions and produce strong risk-adjusted returns. Risk-adjusted returns help to reveal whether a fund's performance is due to good investment decisions or to taking on undue risk.

Funds such as the AQR Risk Parity fund (AQRIX) and Invesco's Balanced-Risk Allocation fund (ABRYX) have better risk-adjusted returns than their peers, according to a metric known as the Sharpe ratio. Mind you, the funds' absolute returns alone don't look impressive: So far this year they have gained 6.7 percent and 3.4 percent respectively, compared with the 16 percent return of the Standard & Poor's 500 index.

But risk parity funds aren't designed to capture all of a market rally; that's the tradeoff for potentially being safer. Based on healthy flows of cash into the funds, it's clear that investors are content with the opportunity to earn modest gains without worrying about losing their shirt.

But Samuel Lee, an analyst at Morningstar, says he's troubled by risk parity funds' rapid rise. "I don't think investors have rationally looked at the actual research behind the funds," he says. "They just see excellent risk-adjusted returns, and they're piling in."

Like many investing innovations, the risk-parity approach has its roots in the institutional world of pensions and endowments. The institutional pioneer was hedge-fund firm Bridgewater Associates, which launched its All Weather fund in 1996. Today, there are 14 risk-parity mutual funds.

Risk-parity mutual funds resemble balanced funds in some respects. A traditional balanced fund might allocate 60 percent of its assets to stocks--to capture market appreciation--and 40 percent to bonds--to provide income and a cushion for market dips. The argument against traditional balanced funds is that, because stocks are more volatile than bonds, overall such funds are riskier than investors realize.

Risk parity funds, on the other hand, allocate their money based not on asset classes but on risk. Take Invesco's Balanced-Risk Allocation Fund, which has gathered nearly $14 billion of assets since its launch in 2009. The fund deploys its assets in order to equalize risk between stocks, bonds and commodities.

The goal is to keep the fund prepared for a range of economic outcomes. Stocks should stand the fund in good stead when inflation is tame and the economy is growing. High-quality bonds are suited to recession or times of crisis. And commodities can help returns keep pace when inflation heats up.

"I think (investors) are understanding that, as they get closer to retirement, they cannot have a full equity portfolio out there," says Peter Gallagher, head of U.S. retail sales at Invesco. "They need to focus on what happens if the market turns."

Before you plunge into risk-parity funds, you should carefully consider the risks. First and foremost, the funds still have very short track records. For better or worse, early investors will be guinea pigs.

On top of that, risk-parity funds are complex. One way their managers equalize risk across asset classes is through the use of leverage and derivatives. If you can't define these terms, you're probably not ready to invest in the funds.

A good financial advisor can be a big help in evaluating risk parity funds. But as Lee points out, many advisors don't necessarily understand complex products much better than you do. Worse yet, some are financially conflicted--they'll talk up a certain fund because they stand to earn a fat sales commission.

Risk parity funds have attracted lots of believers in the early going. But if you're uncertain, wait and see how their performance plays out. Or stick your toe in the water with a small investment.

"A lot of investors are better off taking very conservative steps," says Lee, "because they don't know or understand the risks of these funds."

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