Understanding Risk Parity Thomas Lee, CFA®, Andrew Spellar, and Paul Bouchey, CFA®

FEATURE

The social object of skilled investment return, as represented in figure 1, then income securities were adjusted accord- should be to defeat the dark forces of time the asset classes that fall along the secu- ing to their respective levels of risk, and ignorance which envelope our future. rities market line (SML) are assumed then the excess return expected from —John Maynard Keynes to all have similar risk-adjusted returns equities would equal the excess return over time. In other words, if the expected from bonds (where excess he most important decision expected returns for equities and fixed return is defined as the expected return any investor makes, ahead of T manager or security selection, is FIGURE 1: SECURITIES MARKET LINE a portfolio’s asset allocation. A decade of challenging markets, particularly for equities, has led to growing investor Equities interest around risk parity. This article seeks to explain what risk parity is and how it offers investors the potential to Bonds Retur n achieve superior risk-adjusted returns relative to a portfolio with a traditional

asset allocation. This article also iden- Expected tifies the key differentiators among the various risk parity strategies and addresses some common investor con- RF cerns about the strategy.

What is Risk Parity? Systematic Risk Flatten the securities market line by equalizing the level of risk through leverage or In its simplest form, risk parity seeks to extended duration opens up countless diversification opportunities. For illustrative purposes only. balance the contribution to total portfo- Source: Clifton Group lio risk from each asset class that com- poses a diversified portfolio. A tradi- FIGURE 2: WHY RISK PARITY? tional 60-percent equity/40-percent fixed income portfolio, which is the Benefit of Risk Diversification and base of many investors’ portfolios, is not Efficient Portfolio Risk-Diversified Leverage Construction diversified. Approximately 90 percent Portfolio Leveraged 100% to 60/40 Risk Level of the risk in this traditional portfolio Equities Capital is concentrated in equities, due to the Market fact that historically equities have been Retur n Line 60/40 Risk-Diversified Portfolio three times more volatile than fixed Portfolio income securities. Risk parity seeks to Expected 100% avoid this concentration of risk through Bonds the construction of a more diverse, risk- balanced portfolio. Risk parity’s theoretical underpin- nings come from the same modern Risk portfolio theory (MPT) that underlies Traditional asset allocations are flawed in their design, structurally biasing the investor to risk premiums traditional portfolio asset allocation. If which will disappoint at all the wrong times, as the correlations which they rely upon are unstable. one believes that there is a consistent For illustrative purposes only. Source: Clifton Group long-term relationship between risk and

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above a cash return). This theory holds be adjusted to contribute the same total fer to target a higher level of risk, while true when the slope of the SML is con- level of risk and therefore similar an investor with a shorter time horizon stant. Economic theory supports this expected returns, then choosing would be inclined to seek a lower level outcome to the extent that the SML between asset classes is no longer of risk. Both investors would hold the represents the capital structure of a important. This is not the case. If all same asset classes and thus own simi- dynamic economy. According to the asset classes had the same expected risk, larly diverse portfolios. The only differ- theory, if any component of the capital then the selection of which asset classes ence between the portfolios would be structure were to become significantly to include in the portfolio should be notional exposure required to achieve more efficient at delivering returns driven solely by the asset class’s diversifi- the investor’s target risk level. than another, free market forces would cation benefit. Put another way, if the Most risk parity strategies target a respond and remove the advantage. question of expected return is removed 10-percent level of realized risk. This is If one accepts the premise that the from the portfolio construction process, the level of risk historically exhibited by risk-adjusted returns of all asset classes then the focus is shifted to managing the traditional 60/40 portfolio. At this are equivalent, then a portfolio holding risk through portfolio diversification. risk level, a risk parity manager gen- diversified asset classes that each con- A less discussed, yet important, erally expects to generate 6 percent of tribute equally to risk should produce advantage of a risk parity approach is annual excess return. Over the past 25 superior risk-adjusted returns relative to its potential to realize significant incre- years, a traditional 60/40 portfolio has a traditional 60/40 portfolio. This point mental returns through rebalancing. generated approximately 4 percent of is defined in figure 2 as the risk-diversi- The amount of excess return generated annual excess return. fied portfolio. This portfolio depicts the through rebalancing is a function of asset How Are Risk Parity Strategies maximum diversification benefit from class volatility and diversification. All else Differentiated? holding the various diversified asset being equal, the more volatile and diver- class exposures. However, it includes sified the assets within a portfolio, the Constructing a portfolio based on risk significant allocations to lower risk, more value that can be created through and diversification benefits requires lower expected return assets, such as rebalancing. In the risk parity portfolio, measuring an asset class’s risk and its bonds. Consequently, this portfolio assets are selected based on their diversi- correlation to other asset classes. The would not meet the return expectations fication benefits and levered up or down normal measure of risk for an asset of most long-term investors. These to achieve target volatility. This construc- class is its annualized standard devi- investors compensate for the expected tion process creates an ideal environ- ation of returns over some defined return shortfall by gravitating up the ment for systematically harvesting gains period. There is a decision to be made, efficient frontier toward portfolios that in the portfolio through rebalancing. however, with respect to the appro- comprise higher allocations to riskier It is worth noting that a risk parity priate time period over which to mea- assets (e.g., 60/40 portfolio). This move strategy can target any level of port- sure the standard deviation. A short- is executed with the expectation of folio risk and thus any level of excess term measure of risk may capture achieving higher returns, however, the return. Theoretically, an investor with a changes in risk regimes, but is depen- outcome is the surrender of diversifica- relatively long time horizon would pre- dent on the manager selecting the cor- tion benefits. Risk parity is designed to help inves- FIGURE 3: S&P 500 INDEX, ROLLING 10 YEARS DECEMBER 31, 1982, TO DECEMBER 31, 2012 tors maintain a portfolio with significant risk diversification benefits while still 25.00% meeting their return expectations. This 20.00% result is achieved through the prudent 15.00% use of leverage. Specifically, leverage is employed within the risk-diversified 10.00%

portfolio to move it further up the capi- 5.00% tal market line to the point where it becomes risk equivalent to the 60/40 0.00% portfolio. The resulting levered risk- –5.00% diversified portfolio has a higher expected return than the 60/40 portfolio Dec-82 Dec-85 Dec-88 Dec-91 Dec-94 Dec-97 Dec-00 Dec-03 Dec-06 Dec-09 Dec-12 with an equivalent amount of risk. Some Source: Clifton, Bloomberg Total Return Volatility have argued that if all asset classes can

rect time frame. As figure 3 illustrates, FIGURE 4: CORRELATION BETWEEN S&P 500 AND TREASURIES, a long-term measurement of risk will ROLLING 10 YEARS DECEMBER 31, 1982, TO DECEMBER 31, 2012 miss these short-term changes in risk regimes but should lead to a more accu- 1.00 0.80 rate measure over time, as volatility is 0.60 mean-reverting. Choosing an appro- 0.40 priate time period for measurement 0.20 0.00 depends on how the investor thinks (0.20) of the portfolio. An investor looking (0.40) for a tactical strategy with a compo- (0.60) (0.80) nent of active risk will be more open (1.00) to an approach that measures risk over shorter time horizons. Conversely, an Dec-82 Dec-85 Dec-88 Dec-91 Dec-94 Dec-97 Dec-00 Dec-03 Dec-06 Dec-09 Dec-12 investor seeking a strategic investment Correlation to U.S. Treasuries Source: Clifton, Bloomberg approach with minimum active risk will gravitate toward strategies that measure Common Criticisms of Risk Parity risk over longer periods. Rising interest rates. A gradual rise Correlations provide another point of Like all investment strategies, risk parity in interest rates as a result of a period of differentiation between risk parity strat- has its detractors. Their points are sum- economic stability and prosperity would egies. Figure 4 shows the rolling cor- marized below. be positive for a risk parity approach. relation between the S&P 500 and U.S. Leveraging low-risk assets. One Although bonds may underperform Treasuries. As figure 4 illustrates, corre- common criticism is that this strategy in this environment, growth assets lations are not stationary. In fact, asset requires leveraging low-risk assets, such as equities, real estate, and credit class correlations change dramatically primarily bonds. Risk parity allocations spreads would likely exhibit above-aver- through time. A risk parity manager create an overweight to bonds in order age performance. If interest rates rise in must carefully consider correlations to equalize the contribution to risk from response to increases in inflation expec- between various asset classes in con- all asset classes. Levered bond strategies tations, a risk parity approach should structing a diversified portfolio. As performed well over the past several benefit from exposure to inflation- figure 4 demonstrates, static estimates of years as interest rates declined sharply sensitive asset classes such as commod- correlations are problematic. Forecasting with the onset of the financial crisis in ities and inflation-linked bonds. In sum- future correlations is a complex exercise 2007. Risk parity critics note that given mary, because diversification is central that is fraught with challenges. today’s interest-rate environment, inves- to a risk parity strategy, there will likely An alternative to explicitly calculat- tors should have tempered expectations always be some asset classes in the ing historical asset class correlations is for the performance of their bond hold- portfolio performing below expecta- to take fundamental economic drivers ings in the future. These critics may miss tions. However, at the same time other into account. Factors such as growth and the objective of a risk parity approach, asset classes may well be performing inflation or, more specifically, how those which is to have equal contributions to above average. The goal of the strategy economic variables perform relative to risk from all asset classes in the portfo- is to allow the investor to collect the expectations, are primary drivers of asset lio. The purpose of seeking equal contri- average risk premium across all asset class returns. A manager therefore could butions to risk from varied asset classes classes over time in the most efficient construct a portfolio with asset classes is to limit the potential economic impact manner possible and thus realize a that react differently to changes in these to any one asset class in the portfolio. By superior risk-adjusted return. economic variables and achieve a high equally weighting risk across a broad Leverage. Another criticism leveled degree of diversification. This construc- array of other asset classes such as at risk parity is that it often employs tion process does not require an explicit equity, real estate, credit spreads, com- leverage. Risk parity strategies target a estimation of asset class correlations. A modities, and inflation bonds, risk parity total level of portfolio volatility com- risk parity investor should understand is not dependent solely on bonds as the mensurate with an investor’s risk and how its manager addresses correlations source of diversification or return. It is return objective. To achieve this objec- in the portfolio construction process, important to note that a rise in interest tive, a risk parity strategy may employ because this decision has the potential to rates would impact a risk parity strategy economic leverage in the form of futures introduce a significant amount of active in different ways, depending on why contracts and financial leverage in the risk into the strategy. interest rates were rising. form of repurchase agreements and

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over-the-counter swaps. At a 10-percent folio was not “balanced.” Risk parity for informational purposes only, was risk target, it is not uncommon for a represents a new incarnation in the prepared for academic and institutional risk parity manager to have 200-percent investment allocation process. Although audiences, and is not meant to recom- cumulative exposure. This amount of the concepts related to equalization of mend any specific investment services. leverage is required to equalize the risk risk and diversification are not new, all Risks: The global balanced risk strat- contribution from low-risk assets such of the benefits of a portfolio with these egy involves certain risks. One or more as nominal and inflation-linked bonds. characteristics have not been broadly combinations of the following risks may Leverage by itself is not a problem. understood. At the highest level, risk be incurred: market risk, leverage risk, Anyone who has used a mortgage to parity attempts to deliver superior risk- margin/liquidity risk, and regulatory finance the purchase of a home has been adjusted returns through the construc- risk. There is a risk of loss. Information exposed to leverage. What is critical is tion of a risk-balanced portfolio. If done provided is general information regard- how that leverage is managed. It is here correctly, theory supports that the risk- ing risk parity and does not take into that the diversification prevalent within balanced or risk parity portfolio can account any investor’s particular invest- the portfolio and the operational and achieve this desired objective. ment objectives, strategies, tax status, or implementation experience of the man- investment horizon. We encourage you to ager are important. Diversification must Thomas Lee, CFA®, is a senior portfo- speak with your legal and tax advisors. be considered not only at the total port- lio manager with The Clifton Group, folio level but also among the various a division of Parametric Portfolio asset classes that are levered within the Associates, based in Minneapolis, portfolio and therefore may require daily MN. He earned a BS in economics liquidity. Proven operational experience and an MBA in finance from the in managing leverage is key to risk par- University of Minnesota. Contact ity managers. This experience should him at [email protected]. include having systems in place to monitor leverage levels on a real-time basis Andy Spellar was a portfolio man- and developed plans for managing the ager (2011–2013) with The Clifton strategy through challenging market Group, a division of Parametric Investments & Wealth Monitor environments. Assuming the diversifica- Portfolio Associates, based in tion and experience criteria are met, the Minneapolis, MN. He earned a BA in Mobile App amount of leverage employed in a risk history and European studies from parity strategy should not create exces- George Mason University, and an The Investments & Wealth Monitor sive risk to the investor. MBA with a concentration in finance App is now available for Apple iPad from Marymount University. and iPhone, Android devices, and Conclusion Kindle Fire.

This article presents arguments that Paul Bouchey, CFA®, is a managing • Read current and past issues of support a risk parity approach to invest- director of research with Parametric Investments & Wealth Monitor, ing. The history of asset management is Portfolio Associates in Seattle, free for IMCA members all about evolution. After the Great WA. He earned a BA in mathematics • Download available issues and access them offline at any time and physics from Whitman College Depression, equities were considered • Read topical industry-related speculative and prudent investors held and an MS in computational finance content on the go portfolios heavily weighted toward fixed and risk management from the • Search the archive of available income. In the early 1960s, investors University of Washington. Contact issues • Bookmark your favorite articles began to gravitate back toward equities him at [email protected]. • Read articles in magazine-page with a balanced framework that ulti- or text formats mately moved them to what has become • Share content with colleagues known as the traditional 60/40 alloca- Parametric Portfolio Associates, LLC via e-mail and social media tion, which is at the core of many inves- is a registered investment advisor. The To download the free app, visit your tors’ portfolios. This traditional bench- views and opinions expressed in this device’s marketplace and search mark allocation has been the mainstay presentation are those of the authors “Investments & Wealth Monitor.” for many investors until the recent and may not refect or represent those ® financial crisis. The crisis helped inves- of the firm. All information contained IMCA tors to understand that the 60/40 port- herein is believed to be accurate, is