(Bloomberg) -- The $400 billion corner of quant investing known as risk parity has a history of doubt and division, and Bridgewater Associates has started a new chapter.

Ray Dalio’s $138 billion asset manager has tweaked its version of the strategy by moving into alternatives to conventional bonds as yields hit historic lows, a person familiar with the matter has confirmed.

The shift, telegraphed by the firm in a July report, drives a new wedge between Bridgewater and risk-parity purists and speaks directly to concerns that have long dogged the systematic investing approach.

Since the strategy allocates money across assets based on how risky they are -- meaning it buys more securities with lower volatility -- it typically takes a heavy position in sovereign debt.

“It is pretty obvious that with interest rates near zero and being held stable by central banks, bonds can provide neither returns nor risk reduction,” a team led by Co-Chief Investment Officer Bob Prince wrote in the July report.

Bridgewater’s famous All Weather portfolio has therefore been moving into gold and inflation-linked bonds, diversifying the countries it invests in and finding more stocks with stable cash flow.

The idea is to replicate the long-term positive returns typically generated by bonds while finding alternative ways to hedge a downturn in stocks, especially if higher inflation upends low-yielding nominal debt.

Risky Business

Bridgewater’s conviction that ultra-low yields are a game-changer for risk parity will resonate with many on Wall Street, who have also been fretting over the fate of traditional portfolios that allocate 60% to stocks and 40% to bonds.

Read more: GMO Says Treasuries Have Lost Their Appeal in Zero-Rate World

According to the firm, about 80% of local-currency government bonds have been trading below 1%, which limits the room for such notes to rise in value during a bout of risk aversion since investors can simply hoard cash instead.

That, combined with the potential for losses if yields jump from record lows, means that the world of government debt is potentially losing its function as a safety valve in portfolios.

Not everyone in the industry shares that view. While Dalio is a pioneer of risk parity -- he first crafted it to manage his personal trust in 1996 -- Edward Qian, CIO for multi-asset investments at PanAgora Asset Management, was one of those to help coin the name in a seminal 2005 paper. He’s keeping faith in the traditional version of the rules-based strategy.

“You cannot just say because bond yields are low, they’re going to rise and let’s not invest in government bonds,” said Boston-based Qian. “That’s contradictory to the risk-parity approach.”

There’s plenty of disagreement in the industry over how to define and execute risk parity, but the general idea is to award weightings in a portfolio based on each asset’s volatility and then apply leverage to boost returns. The aim is to achieve similar results to riskier strategies but with a smoother, safer ride.

PanAgora is telling clients to stick with government bonds for their diversification value, rather than try to guess what their future returns will be.

“Predicting inflation is just as difficult as predicting bond yields,” said Qian. “Risk parity is predicated on that predicting asset price is very difficult so you’re better off with a diversified portfolio.”

Read more: We Asked Risk-Parity Practitioners If We Should Worry About It

That approach has boomed in the post-crisis era, as rallies across bonds and stocks helped a benchmark for the strategy gain around 130% over the past decade. At the same time, it also morphed into a whipping boy for critics that argue its volatility-targeting approach exacerbates selloffs.

Yield Debate

The size and scale of Bridgewater’s changes to the All Weather fund are unknown, and the Westport, Connecticut-based giant has been clear that it sees the adjustments as consistent with its risk-parity framework.

“Our balanced approach to beta has never been about a particular asset allocation, nor has it ever been reliant on any particular asset class,” the firm’s investing chiefs wrote in July.

Philippe Ferreira at Lyxor Asset Management has some sympathy for the Bridgewater concerns. In the medium term, should monetary policy makers signal a return to tighter policy, a jump in yields and drop in equities would spell big trouble for the strategy, the cross-asset strategist said. But in the mean time, it is unlikely to lose favor.

“It looks we are far from monetary policy normalization,” he said. “In an environment where valuations are rich in both equities and fixed income, risk parity strategies might even be more attractive for risk control purposes. They have a substantial allocation to bonds which are protected by central bank purchases.”

Bond Buffer

At Mellon Investments, Roberto Croce rejects the doom and gloom about government bonds.

In a July report, the head of risk parity stressed that yields may be low but for the most part curves are still sloping upwards. That means risk-parity funds that trade bond futures can take advantage of what’s known as a roll-down strategy which exploits the shape of the yield curve.

And as PanAgora points out, history suggests that bonds can still provide protection, even at extremely low yields.

Japan’s sovereign debt has defied innumerable calls of a peak for nearly three decades and has mostly continued to hedge stock moves. It’s been a similar story in the euro area in recent years. Inflation famously never showed up in either place.

Bridgewater’s July report warns that the global bond rally may now be reversing. Japanese yields didn’t even revisit their 2019 low amid the pandemic, German yields have recovered much of their March move and U.S. Treasury yields seem to have found a bottom.

Yet for PanAgora, that hasn’t changed the role of sovereign bonds in risk-parity portfolios.

“People have pronounced the death of risk parity many times,” said Qian. “Risk parity can still be used in a way that’s consistent with the past, but you just have to not be afraid of leverage.”

©2020 Bloomberg L.P.