Risk parity can help investors diversify their portfolios, even if they have a typical portfolio in which 60% of their assets are invested in stocks and 40% are invested in bonds, according to the financial services firm SEI.
Risk parity is a “strategy to get you closer to an optimal portfolio,” J. Womack, managing director for Investment Solutions in SEI’s Independent Advisor Solutions group, told ThinkAdvisor on Thursday.
He and other SEI executives also touted the benefits of risk parity during a recent webinar, “Risk Parity Explained: Addressing the Top 5 Questions We Get On Risk Parity,” that Womack said was targeted at advisors.
Explaining what risk parity is exactly, the SEI executives noted it’s an investment strategy designed to balance the sources of risk in an investor’s portfolio, answering the most obvious question that SEI tends to hear from advisors.
Another common question that the firm gets asked by RIAs and other advisors is where the idea of risk parity comes from, according to SEI.
“Bridgewater was the first major institutional group to outline the strategy,” Womack pointed out. During the webinar, Jim Smigiel, CIO of nontraditional strategies at SEI, provided more details on the history of the strategy.
Another question advisors ask SEI about risk parity is what’s wrong with traditional allocation versus risk-based allocation, according to the firm. Another: How does risk parity compare to a traditional 60/40 strategy?
“On a risk-based allocation perspective, 92% of the risk” in a client’s portfolio tends to come from equity versus 8% for fixed income, Womack told ThinkAdvisor. Therefore, while a traditional portfolio is 60/40, “from a notional or dollar value perspective, it’s approximately 90/10 from a risk perspective” actually, he explained. “So, if what you’re trying to implement is a diversified portfolio, the classic 60/40 doesn’t quite get there from a risk perspective,” he said, adding, “risk is ultimately what drives the vast majority of variation in portfolio returns.”
The fifth most common question about risk parity that SEI gets asked is why the firm includes risk parity in its strategies, according to the firm.
“Clients are comfortable with a 60/40 portfolio,” Womack conceded. After all, “it’s kind of the workhorse of retirement savings here in the U.S.,” he said.
However, he explained: “When you augment a 60/40 allocation with a risk parity allocation, and specifically with our implementation, you end up with a client portfolio that’s more diversified than the 60/40 portfolio from a risk perspective. So, you’ve got incremental risk contribution coming from fixed income,” as well as multiple other assets, including commodities and equity.
Based on results SEI has seen in recent years, “over time we believe that’s going to deliver better outcomes for clients” than just sticking with the traditional 60/40 strategy, he said.
“And we don’t just include our risk parity strategy in the 60/40 sort of portfolio,” he went on to say, explaining: “We have a suite of portfolios that we call our private client strategies that incorporate nontraditional allocations.”
There are, of course, potential costs to not diversifying one’s portfolio. “In general, you are relatively more exposed to equity risk if you don’t diversify than if you do,” Womack noted. That’s especially the case “when equity volatility increases, which usually happens in negative market events” that included the 2008 global financial crisis or the tech bubble bursting or even “intermittent” market corrections like what was seen in the fourth quarter of 2018, he told ThinkAdvisor. “If you can reduce the risk contribution from equity, you can better manage drawdowns,” he said.
Historically, risk parity has been more favorable than 60/40, he said, adding: “If you target the same level of risk as a 60/40, using a risk parity strategy instead of a 60/40 strategy, you end up with a better annualized return experience over time.”
However, it’s “not an either/or proposition when it comes to allocating to the 60/40 or risk parity,” he stressed, explaining investors “can augment a 60/40 allocation with an allocation to risk parity.” For instance, one can potentially allocate 80% of assets to a 60/40 portfolio and 20% to risk parity, and, with that system, you can still “get a better sort of risk return outcome than” with 60/40 alone, he noted.
“It’s really about trying to get to a diversified portfolio that a client is going to stick with over time,” he explained, adding: “An allocation to risk parity can balance the overall risk in the portfolio and reduce the incremental contribution of equity risk relative to risk coming from, for instance, interest rates or inflation.”
He added: “Even if you’re not a huge fan of risk parity, but you do believe in diversification, the diversification benefit of adding risk parity to a 60/40 portfolio should lead you to” making sure that at least “some portion of your portfolio” is “in a risk parity strategy alongside a 60/40 portfolio.”