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Risk Parity: Managed Diversity

The strategic rationale for an asset class is whether it improves portfolio efficiency (i.e., the ratio of return-to-risk). The intransigent nature of expected returns and the measurable benefits of diversification implies that the risk component is more amenable to management. This statement does not suggest the irrelevance of the new asset class returns. An asset class's addition to the portfolio must achieve either a similar expected return at lower risk or a higher return at an equivalent risk level. For the former objective, adding Treasury Bills to the portfolio reduces portfolio risk and increases efficiency while sacrificing the portfolio’s expected return target. In the latter goal, adding a higher return asset increases risk and may decrease portfolio efficiency. Irrespective of the aim, the addition of an asset class must improve portfolio efficiency.

We take stock of our current inventory before we go to the store to buy groceries. Portfolio management is no different. The starting point for augmenting a portfolio with a new asset is the current risk factor exposure. Equity exposure dominates a traditional portfolio with interest rate risk providing minor diversification. Thus, the investor’s goal is to find an allocation that provides less equity exposure and diversification into the other factors.

Knowing the items available at the store is crucial before you go. A review of the risk factor provides a material insight into the benefits of risk parity. The formerly dominant risk factor, equity, is much less material to risk parity (exhibit 1). Interest rate risk exposure dominates at about 60%. Further, the specific risk accounts for over 10% due to the variability of the factors. These are beneficial ingredients for improving portfolio efficiency for the traditional portfolio. The risk analysis suggests that risk parity provides valuable diversification.

Exhibit 1. Risk Parity & Traditional Risk Factor Exposures

Capital Risk - Portfolio Risk Factor Exposure

Source: Capital Risk calculations. The benchmark is 60% Global Equities (ACWI) and US Aggregate Bonds (AGG). The Risk Parity portfolio targets 16% risk with allocations to fours asset classes, rebalanced daily: US Equities (ITOT), Developed Equities (EFA), Emerging Equities (EEM), and US Long Treasuries (TLH). The period is June 2010 to June 2020. Weights are as of June 2020. The performance is hypothetical and does not reflect an actual investment.

The mix of ingredients is vital to a good recipe. Portfolio construction is similar. The addition of a new asset or strategy requires removing another (although leverage is possible, it’s not considered here). While any of the assets are possible, the risk target and risk factor exposure provide guidance. The risk parity target of 16% risk suggests replacing a similar risk asset, equities. The exposure to interest rates and higher specific risk suggests that it may act as a replacement for fixed income in a portfolio[1]. The goal of the addition is enhanced efficiency.