Risk parity and risk factor Investing
19 February 2014 Vincent de Martel, CFA, Managing Director What is Risk-Based Investing?
Risk-Based Investing Allocating risk instead of capital Risk-Based Investing Risk Parity The special case of risk-based investing where risk allocations are equal
Risk Factor Investing Risk Factor Risk Parity Investing Allocating not to asset classes but to risk factors. Examples: The small cap premium, Liquidity premium
Proprietary and Confidential: This material may not be distributed beyond its intended audience. 1 There is strong evidence of the existence of a investment risk premium
From an empirical perspective From a theoretical perspective
Equity returns compared with inflation since 1871
1000000
100000
10000
1000 Logscale
100 Inflation (CPI) Equities (S&P composite) 10
1 1871 1875 1879 1883 1887 1891 1895 1899 1903 1907 1911 1915 1919 1923 1927 1931 1935 1939 1943 1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011
But risk matters
Source: Market Volatility, R. Shiller, MIT Press, 1989, and Irrational Exuberance, Princeton 2005
Proprietary and Confidential: This material may not be distributed beyond its intended audience. 2 Lessons learnt from 30 years of investing in economic risk
MSCI World Index: most negative monthly returns of the past 30 years
Source: BlackRock, Datastream
Proprietary and Confidential: This material may not be distributed beyond its intended audience. 3 A balanced portfolio
An entrepreneur wants an increase in wealth over a 10-year period with reasonable certainty Decides to diversify by allocating an equal amount of dollars to two projects
Project A - $50m Project B - $50m
Power plant Hyperloop
Chance of losing $50m over 10 years: ≈ 0% 30% chance of losing $50m over 10 years
This is not a balanced portfolio. 99% of the risk comes from project B Why bother with project A in the first place?
Source: Pixabay.com Source: gas2.org
Proprietary and Confidential: This material may not be distributed beyond its intended audience. 4 The experience of investing in equities and balanced portfolios
Drawdowns from previous high for an equities and 60/40 portfolio 0%
-10%
-20%
-30%
60 Equities / 40 Bonds -40% Developed Equities
-50%
-60% 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
We have only just recovered from the losses started in 2007
Source: BlackRock
Proprietary and Confidential: This material may not be distributed beyond its intended audience. 5 Using asset classes to achieve diversification is helpful
Identifying optimal portfolios requires only three pieces of information 1. Expected return 2. Risk 3. Correlations
Covariance matrix
1.0 -0.5 -0.3 0.0 -0.1 0.5 0.8 0.6 0.3 0.4 0.3 0.5 -0.3 0.2 USD.Cash -0.5 1.0 0.8 0.7 0.7 0.0 -0.6 -0.4 -0.1 0.0 0.3 0.2 0.2 0.0 IL.Debt -0.3 0.8 1.0 0.8 0.8 0.3 -0.5 -0.3 0.1 0.1 0.3 0.4 0.2 0.1 Dev.Sov.Debt 0.0 0.7 0.8 1.0 0.7 0.3 -0.3 -0.2 0.0 0.1 0.4 0.5 0.0 0.0 IG.Debt -0.1 0.7 0.8 0.7 1.0 0.5 -0.2 0.0 0.3 0.3 0.5 0.6 0.3 -0.1 EM.Sov.Debt 0.5 0.0 0.3 0.3 0.5 1.0 0.4 0.5 0.8 0.6 0.6 0.7 0.3 0.0 HY.Debt 0.8 -0.6 -0.5 -0.3 -0.2 0.4 1.0 0.9 0.5 0.7 0.5 0.4 0.1 0.3 Dev.Equity 0.6 -0.4 -0.3 -0.2 0.0 0.5 0.9 1.0 0.7 0.9 0.7 0.5 0.4 0.4 Dev.Sml.Cap.Equity 0.3 -0.1 0.1 0.0 0.3 0.8 0.5 0.7 1.0 0.8 0.7 0.5 0.5 0.3 EM.Equity 0.4 0.0 0.1 0.1 0.3 0.6 0.7 0.9 0.8 1.0 0.8 0.7 0.4 0.4 Listed.Private.Equity 0.3 0.3 0.3 0.4 0.5 0.6 0.5 0.7 0.7 0.8 1.0 0.7 0.4 0.5 Infrastructure 0.5 0.2 0.4 0.5 0.6 0.7 0.4 0.5 0.5 0.7 0.7 1.0 0.0 0.2 Property -0.3 0.2 0.2 0.0 0.3 0.3 0.1 0.4 0.5 0.4 0.4 0.0 1.0 0.2 Ex.Energy 0.2 0.0 0.1 0.0 -0.1 0.0 0.3 0.4 0.3 0.4 0.5 0.2 0.2 1.0 Energy USD.Cash IL.Debt Dev.Sov.Debt IG.Debt EM.Sov.Debt HY.Debt Dev.Equity Dev.Sml.Cap.Equity EM.Equity Listed.Private.Equity Infrastructure Property Ex.Energy Energy In practice though, asset class returns overlap
Source:BlackRock
Proprietary and Confidential: This material may not be distributed beyond its intended audience. 6 Asset class returns can be attributed to only six risk factors
Risk Factors Asset Class
Inflation- Real rates protected bonds
Nominal Real rates Inflation bonds
Corporate Real rates Inflation Credit bonds
High yield Real rates Inflation Credit Liquidity bonds
Small cap Real rates Inflation Credit Liquidity Economic equities
Emerging Real rates Inflation Credit Liquidity Economic Emerging equities
Source: BlackRock.
Proprietary and Confidential: This material may not be distributed beyond its intended audience. 7 The fundamental sources of return
Source Description Example
Economic Return premium associated with economic growth Developed equities, commodities, and property
Credit Return premium from lending money to corporations Corporate bonds versus government bonds
Emerging Return premium from investing in emerging market Emerging markets versus developed markets markets equities, bonds, and currencies
Return premium associated with financial market and Small cap equity versus large cap equity Liquidity asset class liquidity risk
Return premium from lending money for a period of Globally diversified inflation-linked government bond Real rates time portfolio
Inflation Return premium from bearing inflation exposure Nominal bonds versus inflation-linked bonds
Proprietary and Confidential: This material may not be distributed beyond its intended audience. 8 Asset classes deliver cash returns + a blend of risk premia. Example 1
Inflation-protected bonds returns
Barclays World Govt Inflation Linked Bond USD Hedged Index Log scale Log
Cash Returns from real rates risk premium Inflation-protected bonds
simulated
Log scale Log + =
actual
Source: BlackRock
Proprietary and Confidential: This material may not be distributed beyond its intended audience. 9 Asset classes deliver cash returns + a blend of risk premia. Example 2
Listed property returns (REITS)
FTSE EPRA/NAREIT Global TR Log scale Log
Cash Real rates Inflation Credit Economic Listed property
simulated
Log scale Log + =
actual
Source: BlackRock Liquidity Emerging markets
Proprietary and Confidential: This material may not be distributed beyond its intended audience. 10 The goal - achieving growth at reasonable risk…
Global pension assets Risk factor portfolio
Overexposed to economic risk Balanced across fundamental sources of return Underexposed to other sources of return
Economic risk Economic risk
Risk factor portfolio versus average pension
Redistribute sources of return and maintain return expectations
As of September 2013. SourceTowerswatson.com (Global Pension Assets Study 2013), Mercer.com (Asset Allocation Survey), FTSE (FTSE All-World index), BlackRock. The top level allocation is 47% equities 34% bonds 18% alternatives 1% cash. Global pension assets include defined contribution and defined benefit plans.
Proprietary and Confidential: This material may not be distributed beyond its intended audience. 11 …and across market environments
The graph below shows the comparative average performance of a risk factor portfolio and 60% equities 40% bonds in four economic regimes defined by growth and inflation changes (1990-2013)
Growth rising Growth rising Growth falling Growth falling Inflation rising Inflation falling Inflation rising Inflation falling
Factor 1.2% Portfolio
RealRates 0.9% 60/40 Factor Factor Inflation Portfolio Portfolio Credit 0.6% Factor Economic Portfolio 60/40 Political 0.3% 60/40 60/40 Liquidity Total return 0.0% Monthly Excess Return -0.3%
-0.6%
Factor portfolio relative allocations: Real Rates 27%, Inflation 10%, Credit 10%, Economic 28%, Political 17%, Liquidity 7%, rebalanced monthly.
Source: BlackRock. Growth rising/falling is defined by a 3-month increase/decrease in US ISM Manufacturing Index. Inflation rising/falling is defined by a 3-month increase/decrease in the 12-month % change of the US PCE Index. Excess returns for each risk factor are reported from January 1990 to January 2013 60/40 Blend: 60% MSCI World USD Hedged net return, 40% Barclays US Aggregate TR, rebalanced monthly.
For illustrative purposes.
Proprietary and Confidential: This material may not be distributed beyond its intended audience. 12 Advantages and disadvantages of a risk factor approach
Pros Cons
Better understanding of return and risk. Asset class No recognized list of factors characterizations can be too broad (e.g. private equity) Use of derivatives and short positions Portfolios more robust to market regimes The need for frequent or active rebalancing of the risk Weighing the addition of new factors or asset classes factor building blocks to the portfolio and how large the allocation should be By itself, using risk factors should not be a superior Better evaluation of benefits of active management approach since both asset classes and risk factors are exactly identical
Proprietary and Confidential: This material may not be distributed beyond its intended audience. 13 We need a better framework for understanding risk and return
Fat
Fat Sugar Sugar Salt Proteins Salt Vitamins
Proteins Vitamins High calorie content, but unbalanced Balanced, but leaves you hungry
Fat
Sugar
The solution? Salt
Same amount of calories as a burger Proteins As balanced as a salad
Vitamins
For professional clients / qualified investors only Summary
• Risk-based investing is expanding into multiple segments
• More crises to come: stay balanced
• Balance fundamental risks not asset classes
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For professional clients / qualified investors only