Bridgewater Associates is one of the pioneers of “risk-parity” strategy, with risk balancing being one of its central tenets.

Instead of looking at stocks and bonds’ nominal risk and returns, Bridgewater made the following arguments (especially true immediately after 2008 before effects of QE)

1. Stocks are inherently leveraged products.  Corporations borrow to fund future growth, be it via M&A, investing in R&D if applicable, or do silly things such as borrowing from bond market to buy back stocks.  Stock prices, therefore, is pricing in a highly levered operation
2. Bonds, on the other hand, are less levered compared to stocks.  They offer less potential return, but they are also less risky (in general)
3. Therefore, a leveraged bond portfolio with higher risk and higher return may be no more risky than an equity portfolio but offer higher returns

Finally, hedge funds (even with Bridgewater at $160bn) generally have much smaller AUM compared to large mutual funds (Fidelity at $1.6 trillion, Capital Group and PIMCO each at $1.2 trillion).  Even without risk-parity, hedge funds would need to use leverage to maintain comparable risk exposures.

Bridgewater on risk-parity

Bonds will perform best during times of disinflationary recession, stocks will perform best during periods of … growth, and cash will be the most attractive when money is tight.” Translation: all asset classes have environmental biases. They do well in certain environments and poorly in others. As a result, owning the traditional, equity heavy portfolio is akin to taking a huge bet on stocks and, at a more fundamental level, that growth will be above expectations

Lowrisk/low-return assets can be converted into high-risk/high-return assets.” Translation: when viewed in terms of return per unit of risk, all assets are more or less the same. Investing in bonds, when risk-adjusted to stock-like risk, didn’t require an investor to sacrifice return in the service of diversification. This made sense. Investors should basically be compensated in proportion to the risk they take on: the more risk, the higher the reward.

Source: Bridgewater – the All Weather Story