Risk Parity: A Focus on Balance and Adaptation
The value of asset allocation is its balance. Diversification is a portfolio construction process to manage risk in the portfolio. The theory's hallmark is that reward occurs only for market risk because diversification easily removes company-specific risk. As the saying goes, don’t put all your eggs in one basket. Blackberry disciples in 2008 who ignored the iPhone know very well how a dominant market leader can change, seemingly, overnight. This insight is sage advice when companies have widely divergent outcomes and forecasting them in advance is colossally tricky.
Trouble arises when applying the same principles at the asset allocation level. First, there is less diversity between the asset classes. Investors are very familiar with the saying that all correlations go to one when markets decline. This saying is a subtle reminder that no equity class is safe when equity markets drop, whether in the US, Europe, or elsewhere. A highly profitable company gaining market share may be less sensitive to the overall equity market direction. Still, the average company that constitutes an index is not.
Asset allocation requires consistently accurate forecasts of expected returns. In asset allocation, the forecast errors cancel each other with many companies and leave the investor with a portfolio resembling the broad market. When there are few asset classes (e.g., an equity allocation between the US, non-US, and the Emerging Markets), the ability to minimize the forecast error materially reduces. The result is that asset allocation under the standard framework becomes a return-maximizing process rather than a risk-minimizing one. In practice, investors constrain the process to limit the allocation to one asset class over the other. This action is the triumph of the need for an acceptable outcome over misunderstanding the tool.
The result of the traditional asset allocation process is that the risk in the portfolio is unbalanced. For a traditional 60% equity and 40% bond portfolio, the equity risk contribution is greater than the whole portfolio (exhibit 1). This extreme outcome occurs because the fixed income factor, specifically Treasury Bonds, reduces overall portfolio risk.[1] In fact, Treasury bonds do not offer a meaningful contribution until their weight exceeds 50 percent (i.e., a 20% equity and 80% bond portfolio). Indeed, weighting a portfolio by asset class does not achieve diversification.
Exhibit 1. Traditional Portfolio Risk Contribution & Asset Weights
Source: Capital Risk calculations. The benchmark is 60% Global Equities (ACWI) and US Aggregate Bonds (AGG). The representative ETF symbol is in brackets. The period is June 2010 to June 2020, and the weights are as June 2020. The performance is hypothetical and does not reflect an actual investment.
The result of these unbalanced risk allocations shows up in the performance metrics. Risk-adjusted returns (i.e., return-to-risk) decline, and return performance is less persistent. The tail and drawdown risks are high due to material equity exposure (exhibit 2). A closer inspection of the data reveals that the portfolio risk measures are roughly proportional to the equity exposure at 60%.[2] In parallel to the risk contribution, this outcome suggests that there is little diversification. It appears that traditional asset allocation is merely a reweighting of equity exposure.
Exhibit 2. Traditional Portfolio Performance & Risk Measures
Source: Capital Risk calculations. The benchmark is 60% Global Equities (ACWI) and US Aggregate Bonds (AGG). Representative ETF symbol is in brackets. The period is June 2010 to June 2020.
Risk parity offers the prospect of better diversification through improving the balance of risk factors in the portfolio. This trait is not the only benefit. In contrast to traditional asset allocation, risk parity synthesizes new information. The adaption of the portfolio manifests in the risk-adjusted return.
Efficient markets adapt to new information. The return and risk of investments are time-varying, not static. The financial markets are where buyers and sellers settle on a price to exchange an investment’s future cash flows. While the latter statement is banal, there is power in it. If the environment (e.g., the economy) did not change, neither would the financial markets. Thus, in a dynamic economy, the financial markets must produce a price for the investments that also changes.
Risk parity rebalances an investment when the market changes in contrast with static asset allocation. Ideally, asset allocation increases risk exposure when the risk is low and reduces risk when it is high. A risk reassessment may occur because of a credit crisis, the popping of an equity bubble, or another market event. Risk parity is agnostic to the risk driver. Instead, the focus is on the degree of risk, which instructs investors to adapt to market events dynamically.
This logic of adaption for risk parity is intuitive. Most investors focus on the efficiency (i.e., return-to-risk) of their portfolio and believe market risk and return are either static or dynamic. These two beliefs result in four possible outcomes for portfolio efficiency (exhibit 3). Portfolio efficiency changes except when return and risk are both static, which is unrealistic in a competitive market. Thus, the preference should be for a process that adapts to changes in portfolio efficiency.
Exhibit 3. Relationship of Return & Risk Variability to Portfolio Efficiency
As risk changes, risk parity adjusts the allocations within the portfolio. The impact on portfolio efficiency is substantial. Risk increases result in lower portfolio efficiency. Risk parity accounts for this information by reducing exposure because of the deterioration in reward to risk. Conversely, as risk declines, risk parity increases allocations because the return to risk improved. If markets are efficient, then these risk parity actions are undeniably logical.
Similar logic applies in the broader context of a portfolio with more than one risk factor (e.g., equities and bonds). Changes in risk result in a different portfolio efficiency for each asset absolutely and relatively. The trade-off within the portfolio is a function of changing risk, which merely allocates to the more efficient assets.
Both allocation methods are consistent with optimizing risk-adjusted return. The difference is the focus: the long-term averages or the current market information. Even this distinction is trivial because the long-term average derives from the short-term numbers. The reality is one of first principles and a belief in efficient markets. If the markets process information efficiently, then using the current data is a viable choice, which is the mechanism that drives risk parity.
Risk parity offers two valuable attributes to a portfolio: balance and adaptation. These qualities manifest themselves in all asset allocation methods through diversification. By construction, it seeks to balance the risk factors exposures across the portfolio by their actual contribution to risk, not an arbitrary asset weighting. By process design, it adapts to new information in the markets by managing the portfolio efficiency. The result for the investors is improved portfolio efficiency and a more consistent return profile through managing risk.
Learn more about the benefits in our Risk Parity Primer and follow our Risk Factor Parity Indices.
[1] The maximum drawdown of global equities was 34%, which equates to 20.4% for the portfolio. This number is lower than the realized number of 22%.
[2] This risk factor calculation measures the varying factor exposure (i.e., the sensitivity to the equity market). This measure differs from the risk contribution that estimates how much each asset class contributes to the overall risk.