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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.