Risk Parity; Another Look at Asset Allocation
The last 3 years of sizzling domestic equity returns and solid bond total returns have left many purveyors of alternative strategies scratching their heads, as their sophisticated approaches have largely fallen short. Following the extreme volatility of the internet bust of 2000-2002 and then the financial crisis of 2008, many new products were introduced to the investing public, many of which drew heavily on research from financial academia. Financial pros found ways to offer hedge funds, fund of funds, leveraged ETFs and much more. Cutting through the clutter of catch-phrases proclaiming that “investing has changed forever”, several interesting themes have emerged, one of which wants to turn traditional ideas regarding asset allocation on its head.
As most of us know it, asset allocation is a process that uses estimates of asset class returns, combined with the historical volatilities of those returns and the correlation between returns to arrive at an “efficient frontier” of allocations. This efficient frontier represents tradeoffs between portfolio risk and return that are optimal. Actually, this method of allocating assets derives from something called “Modern Portfolio Theory” which is a little like “modern jazz” in that it originates from the 1950’s. What are the flaws of Modern Portfolio Theory (MPT)? Recent extreme market volatility has exposed the weakness of relying upon historical correlations and volatility measures, for one. In short, it appeared that through some of the roughest market periods, the diversification suggested by MPT simply did not work. MPT directs incremental assets in an equity oriented portfolio towards asset classes with a low historical correlation, such as commodities or emerging market debt. But these assets classes have all declined together with equities in the so-called “risk-off” markets we have recently experienced. In other words there was near perfect correlation rather than low correlation. We also saw volatilities changing quickly and abruptly. And while returns have been good, it has been anything but a steady ride. All of this has left practitioners and clients looking for better explanations and possible remedies.
Risk parity has been around since the mid-90s and has become more popular in just the last 5-6 years as large institutions with targeted returns became unhappy with a combination of mediocre returns and high volatility. Quite simply, instead of allocating capital, risk parity allocates risk. Most studies of portfolio risk acknowledge that the majority of portfolio risk is derived from equities. In a portfolio of 50% equities and 50% bonds, for example, one study show that 97% of portfolio risk comes from equities. If you dial that back to 30% stocks and 70% equities, 82% of portfolio risk comes from equities. Of course you can simply reduce stocks to a very small allocation like 10% and reduce risk (still 19% of portfolio risk) but where is your return going to come from? The risk parity approach is based on managing risk and therefore a pure approach might allocate equally to risks emanating from equity returns, commodity returns, currency returns and interest rates. But if all the risk comes from equities, how does one allocate risk evenly? The answer is that the risks are managed through the use of leverage, derivatives and active volatility management.
Risk parity recognizes that risk budgeting drives diversification. It is an interesting approach that may well deserve some attention at this time, despite lagging behind more traditional approaches lately (thus the head-scratching). Why? The last 3 years have witnessed some measure of a bounce off the bottom and/or a reversion to the mean following the train wreck in 2008. Risk has been rewarded, although at times it has been more volatile than bargained for. Now that we are looking forward, however, we may conclude that this robust bounce is almost over and that the true drivers of returns (GDP, corporate earnings, P/E expansion/contraction and dividends) suggest more modest returns going forward. In this macro-oriented “risk-on, risk-off” environment, risk parity approaches may well find a home in many portfolios.