Disclaimer: The article below discusses certain investment strategies, some of which I am currently using in my personal portfolio and some of which I am not. Do your own due diligence before making an investment decision. It’s your money; you’re the best person to judge what is best to do with it.
Risk parity was a craze about five or six years ago, especially in the institutional world. New mutual funds launched in the past eight years now give retail investors a chance to invest in this product if they so choose. Risk parity received a lot of positive press due to the unique way it builds a diversified portfolio. As opposed to a traditional stock and bond portfolio, or a portfolio dominated by private investments like those used in the Endowment Model, risk parity aims to equalize risk across different asset classes and through different economic cycles. Instead of focusing on a capital allocation, it focuses on a risk allocation.
The best way to think about the theoretical underpinnings of the strategy is that risk parity is a “set it and forget it” type of portfolio. It’s built with a set of assets that do well in both growth and recessionary environments as well as assets that do well in inflationary and deflationary environments. As opposed to large upswings and devastating downswings, it’s built to provide a steady return with minimal downside risk, regardless of the market environment. You’ll never have a massive one year return but you also won’t see substantial losses. Once you allocate money to a risk parity fund, the marketing teams behind risk parity strategies would tell you that you have a true “Gone Fishin” portfolio.
Unfortunately, while the story is great, the reality can be very different. First and foremost, there is no standardized risk parity portfolio that would serve as the equivalent of a risk parity index fund. Investment managers have to make very active decisions about how to construct the portfolio. In this way, risk parity is just an asset allocation version of smart beta – active construction and passive implementation. The second problem is that the portfolio construction process is highly sensitive to the data inputs. As we’ve recently learned, the data sucks. Finally, risk parity wholly depends on the use of leverage – potentially dangerous in some environments and catastrophic in others.
Regardless of the problems, the concept of risk parity is instinctively very attractive. Who wouldn’t want a single fund that offers a full asset allocation solution that, while never knocking the socks off in any market, provides steady returns through every market? With that in mind, let’s dig in and see if the positives outweigh the negatives.
Basis for Risk Parity
In most portfolios, risk is dominated by equity or equity-like investments. In a simple 60% S&P 500/40% Barclays Aggregate portfolio, the S&P 500 component accounts for roughly 95% of the portfolio’s risk! Risk attribution is a common statistical lookback measure (it can only be measured after the fact) that uses the volatility of the asset, the correlation of the asset to the entire portfolio, and its weight in the portfolio. The asset with higher risk and a large allocation will ultimately dominate the overall risk of a portfolio. For a stock and bond portfolio to have an equal risk, you need the bond component to be four times bigger than the equity component. That shouldn’t shock anyone given that stock volatility has averaged near 15% in the US compared to 4% for bonds.
Lower volatility assets, however, tend to have much higher Sharpe Ratios than higher volatility assets. The Sharpe Ratio is the ratio of return (total return above cash) relative to risk (volatility). Since 1990, the Sharpe Ratio for the S&P 500 is 0.49 (for every 1% of return above cash, you had 2% volatility), while the Sharpe Ratio for the Barclays Aggregate is 0.84. From a return relative to risk standpoint, the Barclays Aggregate is nearly twice as efficient as the S&P 500. Of course, the problem is that lower volatility assets have a much lower return than higher volatility assets (the S&P 500 has annualized 9.8% since 1990, while the Barclay Aggregate has only annualized 5.9%) and you can’t earn enough return by solely investing in low risk but low return assets. To quote another favorite market truism “You can’t eat Sharpe.”
In fact, the entire concept of risk parity began with theories put forth by William Sharpe. His work on the capital asset pricing model (CAPM) led to the idea that you can get a more efficient portfolio by using leverage. In other words, you can either get more return for the same level of risk or the same return for less risk by leveraging up the most efficient risk/return portfolio. The idea looks something like this:
Risk parity is built on this premise. As opposed to starting with a 60/40 portfolio that is dominated by equity risk, take a 20% stock/80% bond portfolio (a more equal risk allocation) and use leverage to get to a sufficient level of expected return. That, at its core, is the basis that William Sharpe was working with. From there, risk parity strategies add in assets like inflation-linked bonds (TIPS), commodities, and others as the manager sees fit. In the end, the portfolio goes from heavy equity risk to a more balanced risk. Or, better illustrated by the Financial Times:
The risk parity concept was initially developed and put into practice by Ray Dalio at Bridgewater Associates. Bridgewater today is still the largest provider of risk parity product, with its All Weather strategy holding over $100 billion in assets. Through their work with pensions in the 1970s and 1980s, Bridgewater realized that the best long term portfolio was one balanced among different inflation environments and different growth environments. They used a four box quadrant to determine the market environment: rising inflation and rising growth, falling growth but rising inflation, falling inflation but rising growth, and falling inflation and falling growth. Once TIPS were introduced in 1996, Bridgewater had all instruments required to build a true risk parity portfolio. Before then, assets that performed consistently well in inflationary environments were tough to find.
Common criticism of risk parity strategies focus heavily on some of the points I made in the introduction.
- Active Design: There is no theoretical index for a risk parity strategy. There is no S&P 500 or Barclays Aggregate index to compare performance to. While the theory behind risk parity is similar across managers, the construction process is different. In fact, looking at the mutual fund websites, it’s difficult to even know who holds what sometimes! For example, First Quadrant holds REITs, but AQR and Invesco do not. Salient includes a momentum component while no one else does. Some include emerging markets debt, others don’t. In other words, these products can be surprisingly different even if the core philosophy is the same. Much like dividend stock indexes, do your homework and make sure you compare products before deciding on one.
- The Data Sucks: Any strategy that is highly dependent on the data can have a garbage in, garbage out problem. Risk parity is highly dependent on the data. Remember that the primary goal is to take assets with low correlations (a stat based on data) to each other, put them in a portfolio that is more equal risk (a stat based on data), and lever that portfolio up to an acceptable return. If you measure both risk and correlation incorrectly or use only a limited timeframe, future performance invariably does not match the past. Correlations are notoriously fickle and volatilities ebb and flow with the market cycle. Some risk parity strategies, like Bridgewater’s All Weather, use a very long term data history, which smooths this out. Others use rolling time frames. Each of these two is susceptible to different data risks – long term histories use data from market structures that no longer exist and short-term histories are more volatile in their asset allocation.
- Yes, Leverage is Dangerous: Two common counterpoints to criticisms of risk parity is that a well-diversified portfolio is not at risk if leverage is relatively small or that since public corporations have debt, equities are already levered anyway. These counterpoints are hogwash. Portfolio leverage is absolutely dangerous. Remember that every market crash in history was unexpected and a well-diversified portfolio often didn’t protect you much. We don’t know what the future will hold, but any time you introduce leverage, you introduce path dependency.
- Volatility and Risk are Not the Same: I disagree with many of Ben Inker’s (GMO) criticisms of risk parity, but on the topic of volatility and risk not being the same thing, he’s dead on. The only risk to your portfolio is downside risk that causes a permanent loss of capital. Volatility is strictly a measure of dispersion around a mean. These two are not the same. Volatility does not have to mean permanent loss of capital, but leverage sure can. Using only volatility as a measure of risk is potentially a fundamental flaw in design.
The issue with performance of risk parity for retail investors is that there isn’t really a lot out there and the funds have a relatively short lifespan. If you had $25 million to invest, you could certainly gain access to the likes of Bridgewater. Unfortunately, most of the retail products for you and me have only been around for the last five or ten years. All have minimum investment amounts (in some cases, quite high) and all have high fees. All have multiple share classes too, so I’ve tried to choose the one that a typical high income earner might choose. Let’s take a look at the universe:
A special note on the First Quadrant strategy. The inception date is the institutional fund, while the retail funds have only been around for the past eight years or so. They are managed the same, so returns should be comparable. It’s also clear that they have not used the same strategy since 1988 – for example, they have a ~25% allocation to TIPS, which didn’t exist until 1997. Returns prior to then are suspect relative to the current strategy.
On the performance front, it’s very difficult to get a read due to the short history of many of these. Thus far, the best we can say is performance is pretty middling. However, given that we haven’t had any major market events in the last eight years, it’s difficult to judge performance fairly. The returns for the First Quadrant product through time are pretty poor.
Risk parity is a really attractive concept for any investor. Steady returns through any market environment allow for an easy one-time decision and let you put your investing on autopilot. Unfortunately, in practice, risk parity has some issues. The reliance on historical data opens up risks because the data really does suck. The use of leverage introduces path of returns risk that you otherwise would not have.
Further, performance has just not delivered, at least for products available to the average investor. While returns have indeed been middling (as expected for this market environment), the decrease in risk and drawdown has not been there. Based on the data available, risk parity products are something to keep an eye on, but for right now, just don’t seem to make the cut.
Keep building my friends.