Loss Aversion: The Core of Risk Parity
The objective of risk parity is managing risk. A portfolio contains three principal drivers of risk: public markets, strategy, and uncorrelated return (“alpha”). The differentiation between the three is critical to portfolio management.
Public market beta is exposure to traditional assets, including equities and bonds. For US investors, typical indices that measure these returns profiles are the S&P 500 index for US large-capitalization stocks and the FTSE Broad Investment Grade Index for bonds. The price of these exposures is negligible with the advent of zero or near-zero cost ETFs for major stock indices. Beneficially, they are the dominant exposure for most strategies in public or private markets.
Strategy betas are alternative factors that may include value and size for equities, carry trades in currencies, yield curve strategies in bonds, and momentum factors in all markets. While not an exhaustive list, they convey the diversity of markets and strategies employed. They are also the second-largest component of the potential return stream. Crucially, these systemic exposures are accessible through focused ETFs at a low cost. This combination is valuable when constructing a risk parity portfolio.
Alpha or uncorrelated return is a return exposure that is unrelated to the prior two components. In investment theory, this is a measure of the manager's skill with positive values preferred. Complications exist with this factor exposure. Identifying active managers with talent in advance of the skill's realization is arduous and compelling research indicates its near impossibility. Even if persistently identifying the manager in advance existed, it may not matter.
Public market and strategy factors dominate index returns. Conveniently, the vast expansion in the number of ETFs over the last two decades permits efficient implementation of the well-reasoned rationale for a factor through ETFs (exhibit 1). The benefits are two-fold. First, the ETFs implement a strategy at a low cost. Second, the liquidity of the ETFs minimizes the execution risk. Thus, these investible strategies increase risk factor accessibility.
Exhibit 1: Deconstructing Risk Factors with ETFs
Source: Capital Risk. This illustration is hypothetical and solely intended for demonstration purposes.
Since any active strategy is a zero-sum game, the exposure to skill is typically not present in a diversified portfolio as underperformers offset outperformers. This statement does not preclude a narrowly focused fund with a handful of managers from generating alpha. That is most likely the only way possible for an uncorrelated return to express itself in a portfolio. Further, some alpha is the price for giving up liquidity (e.g., hedge funds). Risk parity’s expectation is for no meaningful alpha from selection or liquidity because of diversification, which leaves timing as the only possible alpha source.
Risk parity is a strategy. The distinction is vital because a strategy is dynamic and changes positions over time. Conversely, a traditional fund manager is more static and may hold an investment position for years (i.e., value investor). In the former, exposures change over time with time-varying risk premia while constant in the latter. Thus, risk parity's crucial ingredient is to vary the market exposures over time by avoiding risk when it increases.
The mantra of buy-and-hold is as old as investing. The difficulty of timing the market is canon. Yet, in a diversified portfolio, the only way to beat the market is timing. Widely considered the greatest investor of all time, Warren Buffet invests with two dictums. Only buy good companies (properly, don’t purchase bad companies) and buy at a fair price. The first is a tool to manage risk, while the second a comment on when to buy. Static or dynamic returns are irrelevant to risk parity because changing risk indicates when to allocate.
The challenge of return forecasting is complicated and broad in scale. The diversity of companies is immense. Since the total market is the consensus view of the market participants (i.e., fund managers) with specific company views removed, overcoming the forecasting obstacle is inconsequential in a diversified portfolio. Thus, it is possible to extract factor exposures through daily analysis of the index returns. A considered implementation is critical, and ETFs provide liquid and inexpensive vehicles. The benefit is clear: efficiency and liquidity without a trade-off.