Does risk parity make sense in the current climate?

Yes

Jérôme Teiletche

Head of the Solutions Group at Lombard Odier Investment Managers

Investors need predictable income over the long term and that is why portfolios need efficient, diverse returns. This sounds simple, but over the last half-dozen years, most of our post-war assumptions about building portfolios have been holed by crashes or correlations.

Traditionally, allocating capital to different asset classes was enough to achieve a strategic diversification, but success depended largely on accurately forecasting future returns from each asset class. Worse even than a reliance on predictions, traditional capital allocation to equities or bonds that follow market capitalisation indices can increase, rather than diversify, risk. Market capitalisation weightings hold indices hostage to the most indebted borrowers and equity markets have concentrated capital in technology or the financial sector, to cite just two examples from the last decade.

Traditional reliance on equity performance in balanced portfolios and equity market returns over the past 15 years mean the chances of positive returns has turned into a coin toss. Even those convinced that equity markets will bail them out again recognise that, in the meantime, the ride will be bumpier.

We think there is a more robust way to build portfolios that doesn’t come down to a bet on equities. It makes more sense to focus on the creditworthiness of bond issuers or stock price variations. This lets investors allocate capital according to risk.

Investors implicitly put their money at risk and expect to be rewarded in return. Instead of betting on the future, a risk-based allocation can generate returns more smoothly, sidestepping the worst market downturns while capturing the gains.

Risk-based investing, and in particular ‘risk parity’, is more robust because by distributing risks evenly across asset classes, it is indifferent to market environments. By allocating capital to developed equities, emerging equities, sovereign bonds, corporate bonds and commodities, investors can generate returns whether economies are growing or slowing, while hedging against inflation. In addition, by rebalancing the asset allocation the investor tries to keep the risk contribution of each asset equal.

Some argue risk parity isn’t agnostic to economic cycles because portfolio managers simply take bets on bonds. But risk parity takes account of risk contributions of the various asset classes and an equal bet on all its parts. This is different to a traditional portfolio where a 40 per cent equity allocation represents as much as 90 per cent of the total portfolio’s risk.

Most companies have debt on their balance sheets which means that equities are, necessarily, leveraged. A risk parity portfolio may use leverage as well, when allowed by an investor, but it is applied to a highly-diversified portfolio using very liquid instruments, such as bond futures.

It would be misleading to say all risks are diversified with risk parity, because at least one remains: when all asset classes correlate and generate negative performance. At such times, the only place to hide is in cash.

That is why a sound risk parity approach includes dynamic drawdown management which contributes to the reduction of the overall market exposure by increasing the level of cash or reducing leverage. This is a distinct feature that sets apart a small number of risk parity managers, in particular since May this year, where many strategies lacking such management have suffered from rapidly increasing correlations.

Those convinced that economic growth is round the corner favour equities. Those sure of another decline buy bonds. Those expecting inflation want commodities. But for long-term investors who need to catch opportunities and do not have a crystal ball, we believe risk parity is a recipe for more predictable long-term income. 

No

Charles Stucke

CIO of Guggenheim Investment Advisors

Charles Stucke, Guggenheim

Risk parity is a portfolio management framework that advocates the equal weighting of the components of asset allocation by volatility rather than by capital value. These components generally include asset classes such as stocks, bonds, commodities and real estate, or any variety of strategies.

However, any target asset can constitute a unique component as the selection of components is arbitrary.

The concept of risk parity has seen increasing popularity on the back of well-performing and well-known funds employing this framework. Despite this popularity, we see several fundamental flaws with using risk parity as an allocation strategy. Two of these are as follows:

• Risk parity’s use of volatility as a descriptor or measure of risk because the risk of many financial assets and strategies should not be described in this manner.

• Risk parity advocates the use of leverage without an appropriate appreciation for illiquidity.

The criticism we’re making about volatility’s shortcomings in measuring risk does not stop at risk parity. This criticism also pokes holes in many tools used in modern finance: Sharpe ratio, Sortino ratio, value at risk, portfolio optimisation, even modern portfolio theory. Most practitioners know this intuitively, while the academic establishment and users of risk parity often ignore it. Usually, these criticisms are not well received.

The risk parity model of equal weighting by volatility has visual appeal when shown in pie charts or pitch books. In addition, back tests support its adoption. These back tests often show superior trailing performance for portfolios that overweight ‘low vol’ fixed income and credit assets. Advocates argue that Sharpe ratios are higher in less volatile assets, so levering them is more productive than buying risk in equities. But the past 30 years have been a ‘goldilocks’ period for bonds and Sharpes fail as gauges of many of these assets.

Investors using risk parity to justify loading up on and leveraging bonds today may feel very differently about these investments 10 years from now. That is because volatility does not adequately capture the risk of investing in many fixed income assets. The very same investors who talk about fat tails, black swans and non-normal risk distributions regularly ignore this conclusion.

Risk parity ignores the problems associated with illiquidity, particularly when portfolio leverage is applied. The risk parity concept of levering lower volatility portfolios to create the expectation of higher Sharpe and higher returning portfolios unduly discounts embedded balance sheet mismatch risks. Investors may find those expected higher returns were very misleading. Sharpe ratios themselves mislead when applied to assets or strategies with non-normal return distributions.

As evidence, reported returns on illiquid assets often show the effects of smoothing due to the assets being marked rather than priced.

Smoothing tends to reduce reported volatility, in many cases materially. This reduction gives smoothed assets a potentially larger risk parity allocation than their actual risk of loss would indicate. Successful long-term investing requires patience, an eye for value and a robust framework for managing risk. Risk parity unfortunately lacks a strong definition of value and fails in its representation of risk.