By Richard Leong and Jennifer Ablan
NEW YORK (Reuters) - The Federal Reserve and Bank of Japan's actions last week have given a second wind to an alternative investment strategy that relies on cheap money and low market volatility to produce outsized returns.
Risk parity trades, which involve borrowing to take long positions in both stocks and bonds, have been favored by some big hedge funds and other institutional investors starved for yield by eight years of record low global interest rates.
The funds had a rough 2015 when volatility spiked because of concerns about China's economy and tumbling oil prices, prompting investors to yank more than $2 billion from risk parity portfolios, according to Morningstar. Since January, however, they have bounced back as volatility has fallen, delivering on balance returns more than twice as high as the mid-single-digit total returns from this year's sputtering U.S. equity and fixed-income markets.
For example, Bridgewater Associates, which pioneered risk parity investing two decades ago, has seen its $62 billion All Weather fund post a 13.1 percent return from January through end of August.
That rebound looked under threat, however, in the run-up to the Fed's Sept. 20-21 policy meeting when several policymakers seemed to suggest that a rate rise was in the cards and markets turned choppy.
Yet the Fed not only held fire, but also lowered its forecasts for future policy rates, effectively assuring investors that borrowing costs will stay low for longer. The BOJ, on its part, both affirmed its commitment to more asset purchases and made a new pledge to keep 10-year bond yields near current levels around zero.
The central banks' actions have stoked gains in stocks, junk bonds, emerging market debt and other risky assets that risk parity funds target. They also brought market measures of risks of big swings in the stock and bond markets to their lowest so far this year.
"So I would say if the Fed's latest move dampens cross-asset volatility, then leverage applied via risk parity funds should increase," Chintan Kotecha, senior equity derivatives strategist at Bank of America Merrill Lynch in New York.
WILL FLOWS FOLLOW RETURNS?
The question now is whether investors will regain confidence in the strategy that badly underperformed in 2015 and only started delivering again this year. In 2015, Bridgewater's All Weather, for example, lost 7 percent and another, the AQR Risk Parity Fund <AQRIX.O>, lost 8.1 percent compared with fractionally positive total returns for equities and bonds.
While the case to buy risk-parity funds looks solid, investors have so far remained skeptical.
Morningstar estimates that open-ended funds that employ risk parity have seen about $957 million in net outflows in the first eight months of 2016 to $8.50 billion.
Bridgewater, the world's largest hedge fund company, declined to comment or provide data on investor flows.
The Nasdaq-listed AQR fund with around $442 million in assets is on pace for its 12th straight month of outflows.
It has bled more than $200 million since September 2015, according to Lipper data, despite a total return of 14.2 percent so far this year, including a 2.6 percent bounce last week after the Fed meeting.
A spokesman for AQR declined to comment.
ELECTION LOOMS, BUT LESS FEAR FOR NOW
One possible explanation for investor caution is the Nov. 8 U.S. presidential election, which has emerged as a source of anxiety.
Democrat Hillary Clinton and Republican Donald Trump are in a tight race and its outcome can change Washington's course on spending, trade and taxes. The uncertainty tends to make investors nervous and cut their holdings of stocks and other riskier investments.
"That could add as much volatility as monetary policy," said John Bredemus, vice president at Allianz Investment-U.S. in Minneapolis.
For now, though, low volatility prevails in the aftermath of the Fed and BOJ actions.
The CBOE VIX index <.VIX> known as Wall Street's equity fear gauge, is anchored near its lowest level of the year, and Bank of America Merrill Lynch's MOVE index <.MERMOVE3>, which tracks expected bond market volatility three months out, is at its lowest since the end of 2014.
For Bridgewater, AQR fund and their peers, that is a green light to keep betting on a range of risky assets.
"Things are moving in the right direction and that argues for low volatility," said Jeff Kravetz, regional investment director at the Private Client Reserve at U.S. Bank in Phoenix.
(Reporting by Jennifer Ablan, Richard Leong; Editing by Dan Burns and Tomasz Janowski; Graphics by Jiachuan Wu)