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Efficient frontier

How does Risk Parity Work and Why is it Important in Today’s Markets?

Since the Great Financial Crash of 2008, assets have soared in value as global central banks have increased balance sheets, effectively pouring money into the markets.  Over the past decade, assets from stocks to bonds have benefitted from this rising tide of money such that portfolio values have gained tremendously across a continuum of assets.  One such strategy that has continued to post stellar returns is the Risk Parity Strategy, leading to massive inflows over the past decade.    Risk Parity is a portfolio allocation strategy using risk to determine allocations across various components of a diversified investment portfolio within a given level of risk.  This strategy has been tremendously popular, garnering and estimated $400 billion of investments.   

The Risk Parity approach to portfolio management centers around efficient market theory – which states that security prices reflects all relevant information and are fairly priced.  The aim of Risk Parity is to diversify an investment portfolio among specified assets with equal risk contribution.  The typical Risk Parity portfolio consists of an allocation of stocks and bonds, usually different from a traditional 60/40 allocation split where 90% of risk comes from stocks.  Underlying the approach is a generalized assumption that bonds will outperform when stocks underperform and vice versa, counting on a negative correlation between the asset classes.  However, while this negative correlation dynamic has held true over the past couple of decades, the longer-term history reveals that stocks and bonds have often carried a positive correlation relationship during various stages in history.  Ideally, this strategy involves many asset classes, including stocks, bonds , commodities and alternative assets with largely uncorrelated and diversified returns. 

 

Optimal Risk Weighting by Volatility Across the Efficient Frontier

One of the foremost strengths of a Risk Parity Portfolio is its diversification of assets in a given portfolio including commodities, credit, currencies and real estate in addition to the generic bond and stock mix.  Risk Parity strategies seek to construct a diversified portfolio while equalizing risk of individual assets.  The Efficient Frontier describes the optimal portfolio composition that offers the highest expected return for a defined level of risk, which is usually the binding constraint chosen by the portfolio manager or investor.   The optimal portfolio seeks to balance securities with the greatest potential returns within a desired degree of risk, effectively maximizing return for a given level of volatility.   The optimal portfolio composition relies on historical returns and volatilities of given asset classes and assumes a normal distribution.  Markets are often subject to left-tail (Black Swan) events that skews a distribution, but for the purposes of Risk Parity, most strategies nevertheless assume a normal distribution for simplicity purposes.  By allocating assets with equal risk weighting - or differentiated risk weighting tailored to one’s preferences – an optimal portfolio composition is achieved to comprise the best portfolio return per level of risk.  This optimal portfolio potentially improves the Sharpe Ratio, the average return earned in excess of the risk-free rate per unit of volatility or total risk. The yield on short-term US Treasuries is generally accepted as the risk-free rate.  The Sharpe Ratio’s calculation is as such:

 

Sharpe Ratio = (Mean Portfolio Return – Risk-Free Rate) / Standard Deviation of Portfolio Return

 

The Sharpe Ratio is an important metric amongst Portfolio Managers as it highlights a strategy’s relative efficacy given how much risk was taken to achieve a level of return, quantifying this in a simplistic manner that can be compared against other Portfolio Managers.   Across the Fund Management industry, the Sharpe Ratio is used as an important determinant to analyze various strategies and portfolio managers along a uniform metric.  By this measure, Risk Parity portfolios have outpaced most active fund managers over the past 2 decades with a Sharpe Ratio around 1.0, leading to increasing fund inflows into this strategy by market participants, ranging from Pension Funds to Hedge Funds.  The first well-publicized risk parity fund was termed the All Weather Fund for its ability to perform under all market conditions, developed by Bridgewater Associates in 1996 and run by the famous portfolio manager Ray Dalio. 

The SALIENT Risk Parity Index tracks Risk Parity performance using equal-weights across four asset classes while targeting 10% volatility.  The SALIENT Risk Parity Index can be viewed as a benchmark for Risk Parity Strategies

Source: Bloomberg

 

The Historical Correlation between Stocks and Bonds

Since the 1870s, the equity-bond 5-year rolling correlation has been negative for 635 months compared to 1,063 months with a positive correlation.  The conventional wisdom that bonds and equities have a historically negative correlation began around the late 90s when the Greenspan Put effectively backstopped financial crises such as the LTCM episode and Nasdaq Bubble.  In these scenarios, the Federal Reserve, led by Alan Greenspan, lowered interest rates in response to tightening credit conditions, supporting stock market prices with cheaper liquidity.  Henceforth, stock market participants have been conditioned to expect interest rate cuts and lower yields – thus higher bond prices – every time stock markets collapse, underlining the negative equity-bond correlation that has persisted over the past 2 decades. Since 2015, this correlation has been slightly reversing from -60% levels as the Federal Reserve unwinds its Balance Sheet through Quantitative Tapering, contributing to higher yields during a time of higher stock prices.  Coinciding with the current Federal Reserve’s Quantitative Tapering and interest rate increases, the Trump Tax Cuts of December 2017 have boosted corporate profits and contributed to stock market outperformance, partly financed by new debt issuance which has contributed to higher borrowing costs (yields) in the United States.  These two factors explain the simultaneous drop in bond prices and increase in stock prices over the past 12 months, reinforcing the negative correlation between bond and equity prices.  

 

Source: Graham Capital

To put the current negative equity-bond correlation into perspective over the last 140 years, in March of 2015, it registered the lowest 5-year correlation at -68% while the highest 5-year correlation came in December 1986 at 56%.   During the 1980s, former Fed Chairman Paul Volcker was aggressively tightening interest rates to combat stubbornly high inflation, contributing to higher yields.  However, the equity market construed the Fed Chairman’s actions as a sign of confidence that the “inflation dragon” would be tamed and thus, aided by Reagan’s expansionary policies, the stock market posted strong gains.  This led to fantastic gains in both the stock and bond markets in the 1980s.  As the Risk Parity strategy invests in both bonds and equities with an expectation that their returns will be negatively correlated, the worst-case scenario for Risk Parity would be a situation where bond yields are rising (bond prices dropping) and the stock market fell, leading to a positive correlation of negatively-performing assets.  This hypothetical scenario may arise during a time of Stagflation – persistently high inflation combined with high unemployment and low economic growth – a situation that has currently beset the mismanaged and beleaguered country of Venezuela, for instance.

 

Constructing your own, optimal Risk Parity portfolio

Tools such as Portfolio Visualizer has made it easy for investors to construct hypothetical Risk Parity portfolios, either for investment purposes or just out of curiosity.  Simply select "Risk Parity" from the "Optimization Goals" drop-down menu and insert your desired stock or ETF tickers representing preferred asset classes:

Portfolio Visualizer Risk Parity Optimized Portfolio Tool

For example, if you wish to construct a diverse portfolio consisting of Equities (SPY), Bonds (BND), Real Estate, Gold (GLD) and Commodities (DBC), you may input these Exchange-Traded Funds with their corresponding tickers and desired allocation weights into the tool.  In addition, you can specify the historical time period on which to condition the return data.  By clicking “Optimize” to find the optimal Risk Parity portfolio, you may find a portfolio that looks as such:

 

Source: Portfolio Visualizer

Notice that the largest allocation is given to Bonds (BND) at nearly 60%.  This is due to the comparatively low level of volatility versus other portfolio assets.  Drilling down further, the Portfolio Visualizer tool provides historical risk and return data on each underlying asset as well as the optimal portfolio which should reside close to the Efficient Frontier.  This efficient frontier reveals the relative expected return for a given level of risk (represented as a standard deviation), comprised of all the underlying assets, conditioned on data covering your inputted timeframe.   From the example portfolio, you can see the Commodity ETF (DBC) does not provide attractive returns on a standalone basis, but it still merits a 9.7% allocation in the overall portfolio as its returns may provide negative correlation and diversification to the rest of the asset classes.  While other portfolios can be constructed with disproportional weighting on more attractive asset classes ex-ante, this simplistic risk parity portfolio assigns equal weighting to each asset class.   More sophisticated hedge funds and portfolio managers may design other optimal portfolios that seek to maximize ex-ante returns by overweighting attractive assets (in this example, SPY), potentially boosting returns and sharpe ratio performance.   However, the downside to this approach is that the portfolio may be liable to a sharp drawdown if the overweight assets suffer an outlier negative drawdown or “left-tail” event. 

Source: Portfolio Visualizer

 

When is Risk Parity  Liable to Sharp Drawdowns?

While Risk Parity Strategies spread risk through a tailored weighting of assets, the underlying premise of the strategy is a long-only approach to investing.  The typical risk parity portfolio invests most heavily in stocks and bonds and as such, it’s liable to sharp drawdowns when both of these assets suffer declines at the same time.  While the past 20 years of historical data has shown that stocks and bonds are inversely correlated, this doesn’t preclude periods when these assets can be positively correlated.   This particular circumstance occurred in February 2018 when stocks, which had already been selling off after posting a gangbuster January performance, dropped precipitously over 10% in a matter of days. Concurrently, US 10-year yields had already been rising and continued to increase 55 basis points between January and February, hurting bond prices.  The catalyst that set stocks into free-fall was the US Labor Market Report on Friday, February 2nd, 2018, which indicated a much faster pace of wage growth (2.9% year-over-year Actual versus 2.6% Expected), leading to fears of a faster-than-anticipated hiking cycle from the Federal Reserve.  This simultaneous sell-off in stocks and bonds contributed to a substantial sell-off in risk parity strategies with the Salient Risk Parity Index dropping over 7%, from which it has yet to fully recover.

 

Source: Bloomberg

With over $400 billion estimated to been invested in risk parity strategies, a clear concern is a scenario whereby all market participants withdraw their investments at the same time, leading to a spiral-down effect.  The sheer volume of assets tracking this popular strategy presents a cause for concern due to the systematic ramifications it poses should drawdowns lead to more outflows and withdrawals. What type of market environment would pose the most risk to a risk parity strategy?  One in which runaway inflation (lower bond prices) gives way to higher input costs and marginal costs (labor & materials) cutting into the profits of companies and contributing to lower share prices as investors ratchet their profit expectations lower. The February 2018 episode resembled this type of market environment in miniature as investors became concerned with faster-than-expected inflation figures, but it remains to be seen whether these fears culminate into reality going forward.  To find a long-lasting period of stagflation that was incredibly detrimental to risk parity assets, one would have to dig back to the inflationary period of the 1970s. 

 

Risk Parity should continue to provide solid returns in the future

Over a long period of time, Risk Parity generally works as assets normally appreciate over course of history.  As a long-only strategy, risk parity benefits from increasing balance sheets around the world (public and private) as it provides more capacity to buy more assets.  As two of the biggest and deepest markets in the world, bonds and equities should continue to garner inflows and provide returns.  As a portfolio strategy making allocations across components of a diversified investment portfolio within a given level of risk, Risk Parity enables investors to benefit from uncorrelated factors of market beta.  The ideal entry point into this strategy is when the bond premium and equity risk premium are both elevated.  One of the major risks is a sudden shift in correlations of assets including positive correlation between stocks and bonds – a phenomenon that has been quite common throughout history.  Risk parity investors should also be wary about rising inflation and declining profit margins which should hamper this strategy.  With the longest bull-run in US Treasuries in market history spanning nearly 30 years, some extra precaution should be given, especially given the outright level of yields.   This non-negligible fact has undoubtedly boosted risk parity performance over the past 3 decades, especially as a large allocation of risk-weighting in risk parity portfolios is allocated to bonds.  Nevertheless, risk parity should continue to post solid returns going forward and provide investors the tranquility and simplicity to invest within a robust and diversified framework.