Risk Parity in the Spotlight After 50 Years

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Risk Parity In the Spotlight after 50 Years

By Christopher A. Levell, ASA, CFA ®, CAIA ®

isk parity is a simple idea: returns above the efficient frontier by successful long-term investing. To mea- Maximize diversification allowing the portfolio to be levered. sure the benefits of diversification, met- R by taking equal risk in each Despite the soundness of Tobin’s rics such as the Sharpe ratio, a measure investment. This concept can be used idea, the use of leverage by institutional of a portfolio’s excess return per unit of to guide portfolio diversification by investors has long been considered risk, were developed. What does a fully decreasing assets with large shares of taboo. Many investors have a greater diversified portfolio look like? Using the investment risk budget and increas- awareness of the potential dangers of the tools mentioned above, we would ing lower-risk assets. In practice, risk leverage than an appreciation of its ben- look for the portfolio with the highest parity is used in an increasing number efits when prudently used. They may Sharpe ratio—specifically, the tangent of investment strategies and even can dismiss the idea of leverage out of hand, portfolio in figure 1. This portfolio has be pursued at the total portfolio level. without assessing its pros and cons. But relatively low risk; unfortunately, it is Most risk-parity approaches involve attitudes are shifting. Investment pro- also one of the lowest returning portfo- leverage, which has made recent head- fessionals in particular are increasingly lios on the frontier. lines, with reporters questioning the aware of the constraints on portfolio Broadly speaking, investors follow logic behind gearing low-risk assets to performance imposed by arbitrary two main avenues to boosting returns: increase return. This approach, how- restrictions on style, geography, short- taking more beta (or market) risk along ever, is actually an insight that is more ing, and leverage. the frontier, and seeking alpha (or man- than 50 years old. More-open attitudes about mod- ager outperformance). The first tech- Markowitz (1952) introduced the erate leverage have led managers to nique, taking more beta risk, has led to concept of the efficient frontier. Using develop products that exploit Tobin’s portfolios with equity-heavy mixes that assumptions for expected return, stan- insight. Many of these products come have concerned my firm, the indepen- dard deviation of return, and correlations under the name “risk parity.” dent investment consulting firm NEPC, between assets, the efficient frontier for many years. The second technique, Diversification is a graphical depiction of the highest pursuing alpha, is employed in a huge expected return possible for a given level Diversification always has been key to array of products, many of them quite of risk. Tobin (1958) pointed out that the frontier can be improved upon by FIGURE 1: EFFICIENT FRONTIER WITH CAPITAL MARKET LINE adding risk-free investments to the total 20 portfolio. To the left of the frontier, an allocation on the efficient frontier (the 18 tangent portfolio) is combined with risk- 16

free assets (generally cash or Treasuries) 14 to create a line—dubbed the “capital 12 market line”—that represents portfolios 10 with higher returns for a set level of risk Tangent Portfolio RETURN than those on the frontier. 8

The capital market line (CML) also 6 extends to the right and above the fron- 4 tier. Tobin (1958) showed that levering a well-diversified, low-risk portfolio pro- 2 Risk-free Rate duces a risk/return trade-off superior to 0 that of an unlevered traditional portfolio 0 5 10 15 20 25 30 35 VOLATILITY concentrated in risky assets. Put differ- ently, an investor can achieve expected

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successful, but it is more expensive and tions to other assets. We will examine a The allocations of other asset classes, fleeting than market beta exposure. hypothetical asset allocation, first on the such as commodities, expand because Yet there is a third way to increase usual capital basis, and then on a risk of their low correlation to other kinds expected risk and return, one that basis. Figure 2 is an example of a typical of assets. exploits the CML defined above. If risk budget, with a portfolio well-diver- This risk-parity portfolio has an investing and borrowing can be done at sified across liquid asset classes. expected return of 5.9 percent, with a the risk-free rate, then this line can be Notice that many of the portfolio’s standard deviation of 6.9 percent, using drawn from the risk-free rate, tangent diversifying asset classes have 5-percent NEPC’s 2010 assumptions. Regardless to the efficient frontier. allocations, yet their shares of the risk of the risk-free rate, this portfolio has a Portfolios on the CML are more budget range from 0 percent (rounded) Sharpe ratio that exceeds that of most efficient than portfolios on the efficient for several to 9 percent for emerging institutional funds. Unfortunately, its frontier; that is, they achieve more return market equities. Also, equity risk domi- expected return is lower than required at a given level of risk (see figure 1). But nates the risk budget; in this case, the by many programs. This brings us back to position a portfolio along the CML portfolio has a 55-percent allocation to to the use of leverage along the CML. and increase risk and return, leverage is equities, which accounts for 85 percent If we lever this portfolio once, for needed in order to invest more than 100 of risk. 2:1 leverage, we increase the geometric percent in the tangent portfolio. The With thisASSET typical ALLOCATION risk-budget frame- return to 8.9 percent and the standard Sharpe ratio for all portfolios on the work, we can construct a portfolio deviation to 13.9 percent. This is an CML is constant; an investor simply with risk parity—that is, oneTIPS in which Largeattractive risk-returnInt'l profileCommodities that would Global Bonds Small/ 11% chooses the level of risk to be taken.16% each asset class contributes21% an equal Capbe acceptable Equities to most investors, if they High 6% Mid 5% Core Bonds amountYield of EMDrisk. In essence, we “reverse- could Capbecome comfortableEME with the Risk Parity16% 5% engineer”8% the7% process, starting with a distinctive5% risks arising from leverage. One simple way to diversify is to allo portfolio of equal risks from each asset This 1x leverage example is pre- cate equal capital to each asset class. class and thenRISK deriving ALLOCATION the underlying sented in figure 4. Figure 4 reveals the Unfortunately, such an allocation is not capital allocation. Figure 3 reveals the 2010 return and risk assumptions of the efficient, and for Globalthat reason it has been results of thisTIPS exercise. Large Cap 10Int'l liquid Equities asset classes usedCommoditie in the risks Bonds 10% 10% 10% 10% Small/ called “naïve diversification.”10% The tan- With 10 asset classes, each is 10 per- budgets, and the unconstrained efficient gentCore portfolio, Bonds in contrast, tendsHigh to Y ieldhave centEMD of the risk budget, as shown inMid the Cap frontier of all combinationsEME of these 10% 10% 10% 10% 10% allocations that are equally risk-weight- risk allocation section of figure 3. From assets. Note that the efficient frontier is ed, leading to the term “risk parity.” this we derived capital asset allocations based on all long-only, unlevered com- Risk budgeting can be used to calcu- as shown in the asset allocation section binations of assets. The basic risk-parity late the risk allocations of a portfolio by of figure 3. Some asset classes, such as portfolio plots very close to the frontier, asset class, based on the assumed vola- core bonds, gain a greater share of capi- close to the tangent portfolio in figure 1. tility of each asset class and its correla- tal due to their relatively low volatility. Importantly, a risk budget methodol-

FIGURE 2: TYPICAL ASSET ALLOCATION WITH RISK BUDGET

ASSET ALLOCATION Commodities 5%

Int'l Equities Global TIPS Large Cap 5% 30% 10% Bonds High Small/ Core Bonds 5% Yield Mid Cap EME 20% EMD 5% 5% 10% 5%

Global Bonds 1% RISK ALLOCATION

Large Cap Int'l Equities 45% 14% Core High EMD Small/Mid Cap Bonds Yield EME 5% 17% 6% 4% 8%

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FIGURE 3: SAMPLE RISK-PARITY PORTFOLIO WITH RISK BUDGET

ASSET ALLOCATION

TIPS Large Int'l Commodities Global Bonds Small/ 11% 21% Cap Equities 16% Mid High 6% 5% Core Bonds Yield EMD Cap EME 16% 8% 7% 5% 5%

RISK ALLOCATION

Global TIPS Large Cap Int'l Equities Commodities Bonds 10% 10% 10% 10% Small/ 10% Core Bonds High Yield EMD Mid Cap EME 10% 10% 10% 10% 10%

ogy for creating the risk-parity portfolio FIGURE 4: EFFICIENT FRONTIER WITH LEVERED RISK PARITY does not guarantee that it will have the 20 maximum Sharpe ratio. However, we would expect either 18 methodology to produce very similar 16

results. As leverage increases along the 14 2.0:1 Leverage Emerging Int’l line, the levered risk-parity portfolio Equities 12 ASSET ALLOCATION Commodities can achieve returns significantly above 1.5:1 Leverage 5% Small/Mid Cap 10 Int’l Equities those of portfolios along the efficient Large Cap RETURN Large Cap High-Yield Bonds Int'l Equities frontier. Global TIPS8 Tangent Portfolio 5% 30% EMD 10% Bonds High Small/Commodities Core Bonds 6 Equal Weight Portfolio Economic Scenario Method5% Yield EMD Mid Cap EME 20% 5% Core Bonds 10% 5% 5% 4 Before discussing the risks and op- TIPS Global Bonds portunities of leverage, let’s examine 2 Global Bonds another framework for creating risk- 0 RISK ALLOCATION 1% 0 5 10 15 20 25 30 35 parity portfolios. Instead of assessing VOLATILITY prospective risks, returns, and cor- Large Cap Int'l Equities 45% relations, this method aims to have 14% Core High EMD Small/Mid Cap investmentsBonds thatYield perform well across a drive extraordinary returns for tradi- and the economic scenario method—EME 4% 5% 17% 8% variety of6% economic environments. The tional stock and bond investments. lead to similar portfolio allocations. typical economic framework is based In 2000–2002, a “perfect storm” Compared to the asset allocations of on projections of economic growth and of tumbling stock markets and lower most programs and the relic of a “60/40” inflation, very similar to those formu- interest rates was rough on equity mar- equity/fixed portfolio, risk-parity port- lated by my firm (see figure 5). kets and raised pension liabilities, but it folios have much less in equity, much Specific historical periods can be was good for bonds. The overextension more in inflation-sensitive TIPS and tied to each of these inflation/growth of the 1960s and the stagflation of the commodities, and greater international regimes. For any given period, the 1970s led to high inflation. Traditional diversification. As we have discussed, performance of individual asset classes stocks and bonds fare the worst in such a portfolio carries much less risk, has varied widely, in large part due to times of stagflation, now considered by but (if unlevered) delivers lower returns the divergent dynamics of inflation many observers as a plausible threat for than are generally required. and growth. For example, the United the first time in 30 years. Leverage States and much of the rest of the world From a portfolio construction stand- experienced unprecedented disinflation point, all three approaches to achieving So why have investors seeking higher and strong economic growth during the risk parity—a levered tangency portfo- returns not leveraged low-risk portfo- 1980s and 1990s. These forces helped lio, an equally apportioned risk budget, lios? The most likely reason is aversion

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to the very idea of leveraging. Leverage FIGURE 5: ECONOMIC SCENARIO FRAMEWORK has been part of the downfall of many investment strategies and firms, notably GROWTH during the recent credit crisis. A leveraged portfolio can lose more than 100 percent of invested capital. Leverage using margin or prime brokerage is EXPANSION OVEREXTENSION much more expensive than borrowing at the risk-free rate. Finally, because few institutional investors use leverage at INFLATION the portfolio level, there is maverick risk from being different. As addressed in Minahan (2009), RECESSION STAGFLATION leverage is a problem when combined with other factors: • Distressed sales: forced deleveraging triggered by asset losses or changes in borrowing rates or terms • Illiquidity: assets that are hard to sell, tool whose risks and opportunities are management for risk-parity programs or that can be sold quickly only with worthy of evaluation. For some institu- since their creation—a test that they a severe discount tional investors, this may mean employ- passed. By investing in generally liquid • Kurtosis, or “fat tails”: return distri- ing leverage at the portfolio level. The markets with low leverage, managers butions that have a hidden risk of ultimate constraint on any portfolio is were able to avoid distressed sales and large losses its limited total capital. Leverage makes maintain exposure throughout the cri- • High leverage: very high leverage available much more capital efficiency sis. Counterparty management was also can turn small underlying losses into than long-only investments, freeing up critical, and it strengthened as a result of catastrophes assets for alpha sourcing and necessary the crisis. Leverage ratios were cut back These risks call for caution in collateral management. This approach for most strategies, which we believe deploying leverage in institutional has been used very successfully by some was appropriate. The performance of portfolios. Yet leverage also presents an endowments over the past several years. leveraged risk-parity strategies in 2009 opportunity for institutional investors. For many other investors, acceptance depended on the timing of increasing Leverage remains a critical component of leverage may mean finding a place leverage back to long-term targets. of the market economy. Banks use frac- for risk parity in a diversified portfolio. From a return perspective, although tional reserves to back commitments. Fortunately, several investment manag- risk parity aims to protect in multiple Companies use operational leverage ers have introduced risk-parity products economic environments, sudden and to trade off fixed and variable costs. in recent years; indeed, many of our intense deleveraging across the financial Investors in a stock take on the risk clients use such vehicles as alternatives system in late 2008 led to losses for all of the issuer’s balance sheet leverage. to equity or within the global asset allo- risky asset classes. Risk-parity strate- More recently, my firm has recom- cation sleeve of the portfolio. Risk-parity gies typically include an allocation to mended liability-driven investment products have expected returns similar global nominal sovereign bonds, which (LDI) strategies to its corporate clients; to equity, with lower volatility and performed exceptionally well during many such strategies use derivatives to attractive diversification benefits. Those the flight to quality. However, all other efficiently match liability duration with characteristics make them useful to plan asset classes fell, leading to total 2008 limited plan capital. The tremendous sponsors in reducing equity risk without risk-parity returns of around –15 percent growth of derivative markets presents sacrificing expected return. to –20 percent. This record is actually an opportunity to use leverage effi- a compelling testament to the benefits A Note on 2008 ciently; derivatives priced off London of risk-parity investing: The typical Interbank Offered Rate (LIBOR) in How did risk-parity strategies fare dur- risk-parity product, funded out of equity, effect allow institutional investors to ing the massive financial market melt- experienced half of equity losses, while a borrow and lend at near a risk-free rate. down of late 2008? The worst market total portfolio using risk parity lost less Plan sponsors can benefit by regard- conditions since the Great Depression than two years of gains and did excep- ing leverage as a potential investment posed the most severe test of liquidity tionally well in 2009.

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Summary Christopher A. Levell, ASA, CFA®, A 50-year-old insight is highly relevant CAIA®, is a Partner with NEPC Are You and useful in today’s investment environ- in Cambridge, MA. He earned a ment. Risk parity uses basic investment BS in actuarial science from tools: the efficient frontier, risk budget- the University of Illinois at Urbana- LinkedIn? ing, and scenario analysis. Leverage is a Champaign. Contact him at key component of successful risk-parity [email protected]. Network with your peers portfolios and products, and the under- through IMCA’s group. References standing and acceptance of leverage is a Join online at www.linkedin. critical factor in adopting and managing Markowitz, Harry. 1952. Portfolio Selection. com/e/gis/1620107 a risk-parity approach. Investors can use Journal of Finance 7, no. 1 (March): 77–91. risk-parity products to diversify away Minahan, John R. 2009. Looking into the • Business and Social from equities without sacrificing expect- Future Casts Shadows: A Perspective Networking ed return. Risk parity also can be used on Portfolio Theory, Fat Tails, and Risk • discussions at the total portfolio level, to seek an Management, NEPC (May), available at • Jobs optimal unconstrained market exposure. http://www.nepc.com/writable/research_ • news and Article Updates Risk parity is a viable investment option articles/file/09_05_looking_into_the_ • LinkedIN member directory for clients, helping them to deal with an future_casts_shadows.pdf.

uncertain future through the broadest Tobin, James. 1958. Liquidity Preference as ® possible diversification. Behavior Towards Risk. Review of Economic IMCA Studies 25, no. 2: 65–86.

Petruzzi Continued from page 8

Conclusion Acknowledgments of failing businesses, they complained to regulatory authorities. Technological changes continue to The author is grateful to David Whit- SEC Chairman William Donaldson, present new regulatory challenges. comb and Dave Cummings for their the former NYSE chief executive officer Those who stand to win or lose lobby valuable comments. and a Bush appointee, proposed that about proposed rules. The latest rules stock prices should only be quoted in require that automated traders send Christopher R. Petruzzi, PhD, is a full cents to stop traders from compet- orders through software that has been professor of accounting at the Mihaylo ing for orders by simply paying higher approved to control against spurious School of Business, California State fractions of cents. Two other Republican orders that might adversely affect the University, Fullerton. He also is SEC members opposed the suggestion, stock market. As ever, the wisdom of founder and chief executive officer noting that higher fractions of a cent favoring or opposing these new rules of Smart Execution, LLC. He earned would turn into better prices for inves- has been overshadowed by the partici- a BA in economics from Wabash tors. Nevertheless, Donaldson voted pating parties’ financial incentives. College, an MBA from The University with the two Democrats on the SEC Securities markets will continue to of Chicago, and a PhD in finance and to make full cents the minimum quote respond to technological change. The business taxation from the University increment on all stocks in the United big change, however—the change from of Southern California. Contact him States trading at more than $1.00. human beings making transactions face at [email protected]. As a result, liquidity providers now to face to computers that make deci- Endnote compete at the same price, only faster. sions and transact with other comput- Indeed, automated traders now mea- ers—already has taken place. It took 1 See The Origins of Value, edited by William sure their program speeds in microsec- place, for the most part, within just one N. Goetzmann and K. Geert Rouwenhorst, onds, not milliseconds. decade. published by Oxford University Press in 2005.

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