Efficient Markets: Why Risk Parity Works Part 1
The explanation for why risk parity works reside in two parallel theoretical frameworks for investment. The first is modern portfolio theory that connects investment strategy to the public markets. The second is behavioral economics, which connects the strategy deployed to the universe of investment managers. These frameworks provide the rationale for risk management because risk and return vary through time.
The traditional rationale for risk parity is intuitively appealing. Risk parity traditionally argues that it balances exposure to risk factors that are difficult to forecast. An investor who maintains constant and equal exposures to various factors is not required to predict their levels. Through boom and bust times in the factors, gains in one factor offset losses in another factor. This argument is valid if the factors are diverse.
Exhibit 1: Risk Parity Macro Risk Factors and the Economic Environment
The standard macro factors are associated with different states of the economy (exhibit 1). Expanding growth with low inflation is an ideal environment for equities. High growth with high inflation argues for commodities. Low growth and rising inflation support bonds. Low growth and low inflation suggest gold as a store of value. Since these economic states are unknown in advance, persistently accessing them is prudent and avoids forecasting. The benefit is a stable return stream through the economic cycle.
Challenges arrive when factors are related. The role of commodities is to hedge inflation risk. The composition, however, of inflation has changed through time. First, commodities as a proportion of consumer prices are nearly one-half the ratio that they were 60 years ago (exhibit 2). Thus, equalizing risk in a portfolio that includes commodities overstates the impact of commodities.