Risk Parity: everyone is talking about it, but only a few know how it actually works. We had a closer look on the risk-parity approach and analysed if and how it could protect your portfolio in volatile markets.
In the first part of our article series on risk management strategies, we discussed the severe impact financial shocks - tail risk events - can have on a portfolio, and the importance of protecting against them.
There are a few strategies investors can implement to protect their wealth against tail risk events. With many of them – for example, using options - investors have to determine in advance how much money they are willing to loose over a pre-defined period of time. By definition, these strategies are akin to buying an insurance policy, which, aside from incurring in extra costs, may come with a high administrative burden that make them unsuitable for some investors.
However, there is another strand of risk-hedging strategies which could be used to build the investment portfolio in the first place, thereby theoretically doing away with the need to acquire extra insurance. Today, we have a closer look at one of these, the so-called risk parity strategy.
How Risk-Parity Works
Investors should rethink diversification in terms of tail risks. In a typical 60/40 equity-bond portfolio, equities would generally represent about 90% of the portfolio risk – not much diversification, I would say! A bad year, let alone a tail-event, in equities would weigh disproportionally on the entire portfolio. A way to address this is to construct the portfolio so that every asset class has the same marginal contribution to risk. This is calculated on the basis of volatility rather than returns, as volatility is much more stable and hence easier to estimate. However, as volatility assumes a normal distribution of returns, the risk-parity strategy often uses VaR (Value at Risk), as it also accounts for skewness and kurtosis.
For the sake of argument, I constructed a sample portfolio based on the risk-parity-approach. Using volatility, I weighted equities (MSCI World Index) and bonds (Barclays Global Aggregate Index) so that we have an equal risk weighted portfolio. Based on trailing 52-weeks volatility, the portfolio was rebalanced annually. Of course, this approach is far from perfect. For instance, one can overweight the more recent volatility relative to the volatility 52 weeks ago. Besides, the strategy can be implemented across several asset classes rather than limiting it to equities and bonds. However, this portfolio is designed to be a simple illustration of the risk-parity-concept rather than a perfect solution, which, by the way, doesn’t exist.
The next graph compares the risk-parity-portfolio and a typical 60/40 portfolio that is rebalanced annually to its base allocation. From 1991 to date, the risk-parity-portfolio has not only outperformed the 60/40 portfolio by a substantial measure, but has done so with lower volatility.
The risk-parity approach shows its strength over several market cycles. However, investors should make sure that they fully understand the underlying strategy before implementing it. The outperformance of the risk-parity-portfolio strongly benefits from low drawdowns in bear markets, as equity allocation is usually lower compared to a 60/40 portfolio. The flip side of the argument is that its upside capture ratio in bull markets is below one, thus leading to underperformance vis-à-vis the 60/40 alternative. The following graph paints a clearer picture about this relationship. Ultimately, the risk-parity is a low beta strategy relative to the 60/40 approach and as such it should be used over long-term horizons spanning several market cycles.
For all its benefits, the risk-parity-approach is however no bullet-proof strategy, protecting your portfolio against any losses. For instance, equities and bond markets dropped simultaneously in May-Jun 2013 during the so-called “taper tantrum”. This hurt some risk-parity funds; in particular those using leverage.
It is also worth noting that a key driving factor behind the success of risk-parity strategies has been the exceptionally good bond performance over the last 20 years. While both equities and bonds generated annualised growth of 7% over the period, bonds achieved so with 40% lower volatility.
Going forward, it is unlikely that the good performance of bonds will persist. In fact, US Treasury prices could decline sharply as soon as the US Fed starts reducing its bond buying programme. This could have a negative effect on the risk-parity strategy in the short-run. However, as mentioned, the strategy is designed to be used over the long-term, with investors refraining from reacting to short-term volatility.
Risk-parity is one of many portfolio-building strategies. In the next part of our series, we shall analyse a portfolio based on a target-volatility approach. The premise behind this approach is to determine the asset allocation in such a way that the volatility remains constant. It is based on similar principles as the risk-parity-strategy, but the devil is in the detail.
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