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.
Exhibit 2. US Consumer Price Index Composition (1959-2019)
Source: United States Bureau of Labor Statistics.
There is a more significant concern than the declining impact of commodities on inflation and the follow-through to financial assets. The expected return for nearly all commodities is negative in real terms. Crude oil experienced a real return that barely exceeds zero in the historical data (exhibit 3). As the world seeks to go carbon-neutral, the demand for crude oil will fall along with its expected return. The dominance of crude oil in the commodity index ensures the prospect of positive real returns for the index is improbable in the long-term.
Gold is a commodity unlike any other. It has no vital economic purpose besides relative scarcity. Jewelry drives commercial demand rather than industrial applications. This lack of purpose is not the problem; instead, it’s the argument for gold as a store of value. Gold is used defensively during periods of uncertainty, whether driven by lower inflation or growth. Unfortunately, gold experienced a similar long-term return as crude oil: it barely beats zero in real terms (exhibit 3). [1] Thus, Gold’s argument for inclusion is one more of risk reduction and return reduction.
Exhibit 3. Gold, Crude Oil, & US Consumer Price Indices (1901-2019)
Source: Federal Reserve Economic Database.
The argument for an asset’s inclusion in the portfolio includes diversification or increased portfolio efficiency. A prerequisite of both is a positive expected return. The data suggests that commodities, including gold and crude oil, do not meet the hurdle. Their impact on inflation has declined, which makes them less effective as a hedge. Their past real returns barely exceed zero, with their prospective returns even dimmer. Thus, without a rationale for the inclusion of commodities or gold, the asset classes reduce to equities and bonds.
Equities and bonds possess solid economic arguments. Equity returns are prospectively positive. The higher proportion of services (i.e., people) in inflation implies that business, thus equities, is a natural hedge to inflation. That leaves bonds as the counterbalancing asset in public markets and naturally brings up which bonds to include. Corporate bonds are equivalent to Treasury Bond and selling a put option on the equity. The investor is effectively taking a capped return (i.e., the option premium) for the prospect of losing many multiples of this amount. More worrisome is that when equity markets decline, so do corporate bonds as credit risk increases. Thus, the rationale for including corporate bonds disappears as they limit reward for similar risk, while not providing diversification when needed. This trait is counter to the principles of a risk-parity portfolio. It leaves Treasury bonds (i.e., the risk-free asset) as the bond of choice for risk parity strategies. This definition of asset classes for inclusion (e.g., equities and Treasuries) aligns with modern portfolio theory. This outcome is convenient when determining the rationale for risk parity strategies.
Learn more about the benefits in our Risk Parity Primer and follow our Risk Factor Parity Indices.
[1] See Capital Risk’s A Primer on Commodities that shows the long-term return is negative for all commodities except crude oil and gold. While there is an argument for the tactical positioning of commodities in a bond portfolio, the rationale for a permanent position is lacking.