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Risk parity

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Risk Parity is an investment approach designed to equalize investment portfolio risk by allocating funds to a wide range of categories while maximizing gains through financial leveraging. It is also used as a general term that denotes a variety of investment systems and techniques that utilize its principles.[1] The principles of Risk Parity are applied differently according to the investment style and goals of various financial managers and yield different results.

Some of its theoretical components were developed in the 1950’s and 1960’s but the first Risk Parity fund, called the All Weather fund, was pioneered in 1996. In recent years many investment companies have begun offering Risk Parity funds to their clients. The term, Risk Parity, came into use in 2005 and was then adopted by the asset management industry. Risk Parity can be seen as either a passive or active management strategy.

Interest in the Risk Parity approach has increased since the Financial crisis of 2007-2010 as the Risk Parity approach fared better than most other portfolios during that time and given the poor performance of the traditional equity-heavy asset allocation for the decade from 2000-2010. Some portfolio managers have expressed skepticism about the practical application of the concept and its effectiveness in all types of market conditions but others point to its 15 year track record, extensive simulations and stress-testing, as an indication of its potential success.

Description

Comparison of asset and risk allocations

Risk Parity is a conceptual approach to investing which attempts to provide a lower risk alternative to the traditional portfolio allocation of 60% stocks and 40% bonds which carries 90% of its risk in the stock portion of the portfolio (see illustration).[2][3] The Risk Parity approach attempts to equalize risk by allocating funds to a wider range of categories such as stocks, government bonds, credit-related securities and inflation hedges (including real assets, commodities, real estate and inflation-protected bonds), while maximizing gains through financial leveraging.[4][5]According to Bob Prince, CIO at Bridgewater Associates, the defining parameters of a traditional risk parity portfolio are uncorrelated assets, low equity risk, and passive management.[6]

Some scholars contend that a Risk Parity portfolio requires strong management and continuous oversight to reduce the potential for negative consequences as a result of leverage and allocation building in the form of buying and selling of assets to keep dollar holdings at predetermined and equalized risk levels. For example, if the price of a security goes up or down and risk levels remain the same, the Risk Parity portfolio will be adjusted to keep its dollar exposure constant.[7][8] On the other hand some consider Risk Parity to be a passive approach, because it does not require the portfolio manager to buy or sell securities on the basis of judgments about future market behavior.[9][10]

The principles of Risk Parity may be applied differently by different financial managers, as they have different methods for categorizing assets into classes, different definitions of risk, different ways of allocating risk within asset classes, different methods for forecasting future risk and different ways of implementing exposure to risk.[11] However, many Risk Parity funds evolve away from their original intentions, including passive management. The extent to which a Risk Parity portfolio is managed, is often the distinguishing characteristic between the various kinds of Risk Parity funds available today.[6] Moreover, some investors use Risk Parity as a neutral benchmark measurement, while they actively manage their asset allocation using information regarding market forecasts and/or other techniques.[8]

History

The seeds for the Risk Parity approach were sown when economist and Nobel Prize winner, Harry Markowitz introduced the concept of the efficient frontier into modern portfolio theory in 1952. Then in 1958, Nobel laureate James “Bill” Tobin concluded that the efficient frontier model could be improved by adding risk-free investments and he advocated leveraging a diversified portfolio to improve its risk/return ratio.[12] The theoretical analysis of combining leverage and minimizing risk amongst multiple assets in a portfolio was also examined by Jack Treynor in 1961, William Sharpe in 1964, John Lintner in 1965 and Jan Mossin in 1966. However, the concept was not put into practice due to the difficulties of implementing leverage in the portfolio of a large institution.[13]

According to Joe Flaherty, senior vice president at MFS Investment Management “the idea of risk parity goes back to the 1990s”. In 1996, Bridgewater Associates launched a risk parity fund called the All Weather asset allocation strategy which attempted to "achieve consistent performance" and equalize risk by correlating diversification (such as global inflation-linked bonds and global fixed income assets) with exposure to different economic drivers, such as inflation and economic growth.[14][6][15][16] The initial impetus for the All Weather fund was to establish a family trust for the founder of Bridgewater Associates.[16] Although Bridgewater Associates was the first to bring a risk parity product to market, they did not coin the term. Instead the term, Risk Parity was first used by Edward Qian, of PanAgora Asset Management, when he authored a white paper in 2005. The term was later co-opted by the asset management industry and evolved into a portfolio investment category.[14][17] In time, other firms such as AQR Capital, Aquila Capital(2004), Northwater, Wellington, Invesco, First Quadrant, Putnam Investments, ATP (2006) PanAgora Asset Management (2006), AllianceBernstein (2010) and the Clifton Group(2011) began establishing Risk Parity funds.[14][18][19][20]

Reception

With the bullish stock market of the 1990's, equity-heavy investing approaches outperformed Risk Parity in the near term.[21] However after the March 2000 crash, there was an increased interest in Risk Parity, first among institutional investors in the United States and then in Europe.[16][22]USA investors include the Wisconsin State Investment Board which has invested hundreds of millions in the risk parity funds of AQR and Bridgewater Associates.[23][24][25][26] The Financial crisis of 2007-2010 was also hard on equity-heavy and Yale Model portfolios,[27] but Risk Parity funds fared reasonably well.[28][29][30][31]

According to a 2011 article in Investments & Pensions Europe, the Risk Parity approach has “moderate risks” which include: communicating its value to boards of directors; unforeseen events like the 2008 market decline; market timing risks associated with implementation; the use of leverage and derivatives and basis risks associated with derivatives.[32] Other critics warn that the use of leverage and relying heavily on fixed income assets may create its own risk.[33] Portfolio manager, Ben Inker has criticized Risk Parity for being a benchmarking approach that gives too much relative weight to bonds when compared to other alternative portfolio approaches. However, proponents of Risk Parity say that its purpose is to avoid predicting future returns.[34][35][36] Inker also says that Risk Parity requires too much leverage to produce the same expected returns as conventional alternatives. Proponents answer that the reduced risk from additional diversification more than offsets the additional leverage risk and that leverage through publicly-traded futures and prime brokerage financing of assets also means a high percentage of cash in the portfolio to cover losses and margin calls.[27] Additionally Inker says that bonds have negative skew, (small probability of large losses and large probability of small gains) which makes them a dangerous investment to leverage. Proponents have countered by saying that their approach calls for reduced exposure to bonds as volatility increases and provides less skew than conventional portfolios.[37]

Risk Parity advocates claim that the unlevered Risk Parity portfolio, is quite close to the tangency portfolio, as close as can be measured given uncertainties and noise in the data.[38] Theoretical and empirical arguments are made in support of this contention. One specific set of assumptions that puts the Risk Parity portfolio on the efficient frontier is that the individual asset classes are uncorrelated and have identical Sharpe ratios.[26]Risk Parity critics rarely contest the claim that the Risk Parity portfolio is near the tangency portfolio but they say that the leveraged investment line is less steep and that the levered Risk Parity portfolio has slight or no advantage over 60% stocks / 40% bonds, and carries the disadvantage of greater explicit leverage.[35]

Despite criticisms from skeptics, Risk Parity has fared well in the marketplace and has seen a "flurry of activity" in recent years. One recent survey suggested that over 50% of America-based defined benefit pensions and endowments & foundations are currently using or are considering using Risk Parity products.[39] Companies like AQR Capital and Bridgewater Associates have attracted clients such as the Wisconsin State Investment Board, The Pennsylvania Public Schools Employees’ Retirement System and the Alaska Permanent Fund Corp to their Risk Parity funds.[6][35][40][16]

References

  1. ^ [1] Peters, Ed, Balancing Betas: Essential Risk Diversification, First Quadrant Perspective, February 2009, v. 6 no. 2
  2. ^ [2] Maillard, Sebastien, Thierry Roncalli, Jerome Teiletche, On the properties of equally-weighted risk contributions portfolios, Working Paper, May 2009
  3. ^ [3] Ai-CIO, Risk Parity is About Balance, Bob Prince, October 2010, page 10
  4. ^ Peters, Ed, Does Your Portfolio Have “Bad Breath?”: Choosing Essential Betas, First Quadrant Perspective, December 2008, v. 5 no. 4
  5. ^ [4] Allen, Gregory C., The Risk Parity Approach to Asset Allocation, Callan Investments Institute Research, February 2010
  6. ^ a b c d ai-CIO, Defining Risk Parity, Justin Mundt, October 2010, page 9
  7. ^ [5] Fund Evaluation Group, Risk Parity; The Truly Balance Portfolio?, Gregory D. Houser, November 2010, Retrieved June 2011
  8. ^ a b [6] Dalio, Ray, Engineering Targeted Returns & Risks, Bridgewater Thought Leadership
  9. ^ [7] Levell, Christopher A., Risk Parity: In the Spotlight After 50 Years,” NEPC March 2010
  10. ^ [8] Jensen, Greg, Jason Rotenberg, The Biggest Mistake in Investing, Bridgewater Daily Observations, August 18, 2004
  11. ^ [9] Goldwhite, Paul, Diversification and Risk Management: What Volatility Tells Us, First Quadrant Perspective, October 2008, v. 5 no. 3
  12. ^ [10] NEPC, Risk Parity: In the Spotlight After 50 Years, Christopher A. Levell, March 2010, page 1
  13. ^ [11] The Risk Parity Approach to Asset Allocation, Gregory C. Callan, Feb 2010, Callan Investments Institute Research, Page 2, Retrieved June 2011
  14. ^ a b c [12] I&PE, Risk Parity: Taking the Long View, Stephanie Schwartz, April 2011, retrieved June2011
  15. ^ [13] Financial Times, Following the herd risks capital loss, John Plender, January 30 2011, Retrieved June 2011
  16. ^ a b c d Investments and Pensions Europe, The Truly Balance Portfolio, Martin Steward, October 2010
  17. ^ The Institutional Investor, The Last Frontier, Francis Denmark, Sept 2010, page 7
  18. ^ Money Management Letter, The Clifton Group Names New Manager of Risk Parity Strategies, March 1 2011
  19. ^ Global Pensions, AllianceBernstein plans risk parity strategy, Oct 2 2010
  20. ^ [14] Investments and Pensions Europe, April 2011, Case Study:ATP, Henrik Gade Jepsen.
  21. ^ [15] Clarke R., de Silva H. and Thorley S. (2002), Portfolio constraints and the fundamental law of active management, Financial Analysts Journal, 58(5), pp. 48-66.
  22. ^ [16] I&PE, Risk Parity: Nice Idea, Awkward Reality, April 2 2011, Retrieved June 2011
  23. ^ Money Management Letter, PSERS Revamp Cash Management, Oct 18 2010, page 4
  24. ^ Pensions and Investments, Wisconsin Picks Pair For $600 Million In Risk Parity, Barry B. Burr, Jan 18 2011
  25. ^ The Institutional Investor, The Last Frontier, Francis Denmark, Sept 2010
  26. ^ a b [17]Qian E. (2005), Risk parity portfolios: Efficient portfolios through true diversification, Panagora Asset Management, September 2005 Cite error: The named reference "Qian1" was defined multiple times with different content (see the help page).
  27. ^ a b Qian E. (2006), On the Financial interpretation of risk contributions: Risk budgets do add up, Journal of Investment Management, Fourth Quarter.
  28. ^ Choueifaty Y. and Coignard Y. (2008), Towards maximum diversification, Journal of Portfolio Management, 34(4), pp. 40-51.
  29. ^ Lindberg C. (2009), Portfolio optimization when expected stock returns are determined by exposure to risk, Bernouilli, forthcoming.
  30. ^ Martellini L. (2008), Toward the design of better equity benchmarks, Journal of Portfolio Management, 34(4), pp. 1-8.
  31. ^ Neurich Q. (2008), Alternative indexing with the MSCI World Index, SSRN, April.
  32. ^ I&PE, Missed Opportunity?, Mathew Roberts, April 2011
  33. ^ Global Pensions, AllianceBernstein plans risk parity strategy, Oct 2 2010
  34. ^ Asness, Clifford S., Why not 100% Equities, Journal of Portfolio Management, Winter 1996
  35. ^ a b c [18] Risk Parity, Or Simply Risky?, ai5000, May/June 2010
  36. ^ [19] Inker, Ben, The Hidden Risk of Risk Parity Portfolios, GMO White Paper, March 2010
  37. ^ Foresti, Steven J., Michael E. Rush, Risk Focused Diversification: Utilizing Leverage within Asset Allocation, Wilshire Consulting, February 11, 2010
  38. ^ Tütüncü R.H and Koenig M. (2004), Robust asset allocation, Annals of Operations Research, 132, pp. 132-157.
  39. ^ aiCIO. "Risk Parity Investment Survey". aiCIO. Retrieved 12 September 2011.
  40. ^ [20] Pensions & Investments, Wisconsin Picks Pair for $600 Million In Risk Parity, Barry B. Burr, Jan 18 2011
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