September 20, 2012

Why Risk Parity Matters Now More Than Ever

The roller-coaster ride the equity markets have been on for the last few years has led many investors to re-evaluate both traditional asset allocation models that have often fallen short of expected returns and alternative investment strategies that have failed to insulate portfolios from market losses. This has led to a growing interest in the global allocation and risk management strategy known as “risk parity.”

Risk parity is nothing more than an effort to distribute risk equally across key elements of a portfolio that are not only lowly correlated with one another but also linked in different ways to the main economic drivers—growth, inflation and sentiment. In addition, it entails targeting a consistent level of portfolio volatility regardless of changing market conditions.

Most typical asset allocation strategies direct a modest majority of the dollars in a portfolio, usually about 60%, to equity investments. That can be effective during periods of disinflation and positive growth, which describes the 25-year period ending in 2007, according to data from S&P. A longer view of financial history, however, shows that there are extended periods when equities typically don’t perform particularly well but other asset classes, such as bonds and commodities, generate acceptable returns.

For example, data from Barclays Capital, MSCI and Salient shows that if you had invested in the equity market in 1928 before the crash and held that investment all the way to 1950, you would essentially have made no money. Investors often fail to realize that they have anchored their expectations of the market on very recent financial history, and that these results are not necessarily indicative of the economic outcomes we could be facing going forward.

Many investors also fail to truly understand diversification. Diversification is not necessarily a function of the number of managers in a portfolio. It comes from the combination of the underlying asset classes and strategies. An investor may be employing dozens of managers through mutual funds, ETFs and other more complicated structures to purchase hundreds of individual securities, but all those managers are typically driven by what’s going on in the stock market. Investors who want to hedge against changing levels of growth, inflation or investor sentiment could potentially achieve better results by lowering the level of equities in the portfolio and increasing their allocation to commodities, interest-rate-sensitive bonds and other diversifying strategies.

As they say on TV, “don’t try this at home.” Constructing a risk parity portfolio is not a task for the uninitiated. A naïve retail investor might be able to implement a risk parity strategy on her own through the use of ETFs that represent equity, credit, rates and commodities, though it would be considerably more difficult to balance out the risk without some of the mathematical formulas used by investment professionals. The problem with this approach is that an equal dollar weighting across all of those components does not necessarily bring you back to an equal risk rating, although it’s a step in the right direction.

A professionally managed risk parity portfolio typically includes futures contracts or swap contracts. This often gives the manager more flexibility to increase or decrease exposure to these markets as the volatility of each asset class and the correlation of each asset class to all other asset classes rises and falls over time. (ETFs also hold futures and swaps as the main vehicles to give them exposure to the market, but direct execution is not only more precise in terms of risk allocation, but cuts out the middleman.)

Rather than focusing on the percentage of dollars allocated to various investments, most risk parity investors focus on the amount of portfolio risk generated by each component and seek to equalize the risk contribution of each component.

Historically, risk parity strategies have resulted in lower risk at the same level of return when compared to traditional allocation strategies. Data from Barclays Capital, MSCI and Salient not only support that finding, but also show that risk parity strategies have also led to considerably lower peak-to-trough drawdowns during such periods of crisis as 2008-2009 and 2000-2002. For advisors and their clients, that’s something to consider when building portfolios.

Page 2 of 2
Single page view Reprints Discuss this story
This is where the comments go.