Risk Parity Invests Without Compromise
The key to successful long-term investing is managing risk. Risk parity is a meaningful tool for the investor to manage the portfolio’s return profile. Risk management is a critical concern in an environment of low interest rates and highly correlated equity markets. The asset allocation process is long, arduous, and requires experienced professionals using sophisticated analytical tools to ensure value to the portfolio, particularly for the highly uncertain return expectations. Risk parity overcomes these barriers for the investor. The key benefits of risk parity include:
Balance delivers diversification – balancing factor exposures removes the capitalization bias and achieves real diversification.
Adaptation aligns the portfolio – efficient markets process information rapidly, and adaptation aligns the portfolio with new information as it emerges.
Managing risk delivers portfolio efficiency – time-varying returns leave only risk management to deliver portfolio efficiency.
Consistency supports a fiduciary standard – Managing time-varying risk increases the return’s consistency and aligns the investment with the investor.
The practicality of risk parity enables an asset allocation paradigm with risk management at its core. The transparency and liquidity empower a timely transition from the current state to a risk-focused future. Risk parity invests without compromise.
Risk Parity Invests Without Compromise
Diversified portfolios following the traditional asset allocation paradigm experienced unparalleled volatility to financial markets in 2020 as the Pandemic spread across the globe. A recovery followed a sharp drop in the equity markets that were both unprecedented in their speed. Fixed income and commodity markets also fell and rebounded as the threat of higher defaults and less commodity demand loomed. Thus, investors are increasingly sensitive to higher volatility within their portfolio and the prospect of low returns for the fixed income and commodity asset classes. The response is to seek improved portfolio risk management while maintaining the return objective.
There are two challenges for investors when constructing portfolios using traditional asset allocation methods. First, they are contingent on accurate forecasts of expected return. This requirement is particularly onerous when returns did not meet expectations.[1] Second, they do not adapt to changing risk. A crucial determinant of business is managing change: investing should be no different. The result is unbalanced and static risk allocations.
Risk Parity is agnostic to return, which removes the need to divine a highly uncertain expected return. Critically, risk parity dynamically manages portfolio risk to adapt the portfolio as market risk changes. Risk Parity offers an active management paradigm rather than the passive stance of traditional asset allocation. This focus enables the skeptical investor to justify the active management cost by offering another choice to achieve their specific portfolio objectives. Risk Parity invests without compromise.
Learn more about the benefits in our Risk Parity Primer and follow our Risk Factor Parity Indices.
[1] For the 10-year period ending June 30th, 2020, the total return of 60% equities and 40% bonds portfolio was 7.0%, under the return expectation of about 7.5% for the US corporate pension universe. The underlying returns were 9.2% for the iShares ACWI Index ETF (ACWI), 3.7% for the iShares US Aggregate Bond Index (AGG), and 1.2% for the iShares 1-3-year US treasury Bond ETF (SHY).