Should You Fire Your Risk Parity Manager?

Feb 22 2016 | 6:57pm ET

Editor’s note: Risk parity strategies came under pressure in 2015 as markets sold off risk en masse and asset classes fell across the board. The performance was a reminder that the strategy, which relies on diversification across equities, fixed income, emerging markets, commodities, etc. and then using leverage to boost returns from a relatively diluted basket of components, is inherently tied to beta, not alpha. However, the idea behind risk parity remains a sound one over long periods of time, writes Peter Hecht of Evanston Capital Management, as long as investors remember what it is, and what it is not.

Should You Fire Your Risk Parity Manager?

By Peter Hecht, Ph.D.

Let me be frank: Risk parity’s realized performance last year was horrible.  This is confirmed by the 2015 performance of the following simple, U.S.-oriented, risk parity-motivated portfolio consisting of 140% Barclays Agg (bonds), 35% S&P 500 (stocks), and 25% S&P GSCI (commodities), which earned approximately -7% in 2015 (assuming financing leverage is free), which is bad in both absolute terms and relative to the approximate +1% earned by the “incumbent” 60%/40% S&P 500/Barclays Agg portfolio.  

Similar results are obtained using currency-hedged global stock and bond indices, which posted approximately -6.5% and +1% for “global” risk parity and 60%/40% stock/bond, respectively.  Clearly, it’s game over for risk parity, right?

Not exactly.  

Most of the arguments cited against risk parity reflect confusion regarding what risk parity is and what it isn’t, which is critical to understand when trying to hold the strategy accountable.  In fact, the cumulative effect of this confusion led me to write an entire piece on “common risk parity misperceptions” back in 2014. In today’s piece, I will go over some of the more popular, recent criticisms of risk parity and provide an alternative, clarifying explanation.  For a more in-depth analysis, I encourage you to read my original article on common risk parity misperceptions

Criticism #1:  Hedge fund strategies such as risk parity need to make money on a consistent basis.  The negative performance of risk parity is unacceptable. While some traditional hedge fund managers might offer risk parity products, it is NOT a hedge fund strategy.  The goals and risk/return properties for standard risk parity approaches are completely different than hedge fund or absolute return strategies. Standard risk parity is about delivering long only, static, risk-balanced exposure to various traditional betas without incorporating explicit expected return views. In other words, risk parity is a type of public market, strategic (long-run) asset allocation solution. While high quality strategic asset allocations are expected to make money over the long run, the ride along the way can be very bumpy. This defense is not unique to risk parity – the “long only, static” nature of all strategic asset allocations, whether it be risk parity or some other approach, makes it impossible to avoid this “bumpy” reality.

Criticism #2:  Risk parity has recently underperformed a 60%/40% stock/bond portfolio. All strategic asset allocations, including risk parity, are about the long run. In other words, think of a strategic asset allocation as the answer to the following foundational question:  if the investor had to commit to one static portfolio (or risk) allocation over the next ~100 years, which portfolio (or risk) allocation maximizes expected return given the investor’s risk tolerance and other constraints? Therefore, comparing competing strategic asset allocations over the short run, such as risk parity versus 60%/40% stock/bond, is inconsistent with the long-run spirit of a strategic asset allocation exercise. Asking whether risk parity is expected to beat 60%/40% stock/bond over the next ~100 years is the relevant strategic asset allocation question.    

Criticism #3:  Interest rates are going to unexpectedly rise, and risk parity has a lot of bond exposure (or oil prices are going to continue to decline, and risk parity has a lot of commodity exposure).  First, good luck correctly “calling” interest rates or oil prices – both are liquid, visible, competitive markets where investor hubris is plentiful but true information advantages rarely exist. Second, even if one could correctly call interest rates (or oil prices), statements such as “interest rates are going to unexpectedly rise” are tactical (i.e. short term) in nature. With this tactical view, one would hold fewer bonds (or commodities) than the strategic asset allocation implied by the risk parity portfolio.  

However, in no way does this disprove risk parity, nor does it necessarily warrant abandoning the risk parity strategy/framework. Why?  

Think of risk parity as a “starting point” for one’s asset allocation, i.e. the functional role of a strategic asset allocation.  As shown in previous work, this “starting point” risk parity asset allocation is optimal for Sharpe Ratio maximizing investors only when individual asset class, risk-adjusted returns (i.e. Sharpe Ratios) and diversification benefits (i.e. pairwise correlations) are identical. If one has a tactical view (i.e. current risk/return view is different than the equal Sharpe Ratio assumption implicit in the risk parity strategic asset allocation), then adjust the risk parity portfolio weights accordingly. This applies to any strategic asset allocation approach, whether it is risk parity, constrained mean-variance optimization, or some other alternative.  

But wouldn’t this tactical view on bonds, for example, require reducing one’s risk parity exposure?  It depends.  If the investor is starting out with a portfolio of 100% risk parity, then, yes, this tactical view on bonds would warrant a partial risk parity reduction.  However, in practice, risk parity is only one of many strategies within an investor’s portfolio, and, thus, tactical views can be implemented through various portfolio channels. For example, if the risk-adjusted return for bonds is going to be lower than other asset classes (“the tactical view”), the investor can reduce his allocation to his long-only bond manager.       

Criticism #4:  Risk parity has a lot of bond exposure (or is “overweight” bonds) and only works when the starting interest rate is high, which is not the case today. The validity of risk parity has nothing directly to do with the current interest rate. As stated earlier, risk parity maximizes the portfolio risk-adjusted return (i.e. Sharpe Ratio) when individual asset class, risk-adjusted returns (i.e. Sharpe Ratios) and diversification benefits (i.e. pairwise correlations) are identical on a prospective basis. There’s no mention of the current interest rate. Critics of risk parity would need to argue that 1) the current interest rate forecasts bonds’ future Sharpe Ratio, 2) a low current interest rate is associated with a low future bond Sharpe Ratio, and 3) the phenomenon making the prospective bond Sharpe Ratio temporarily low isn’t also making other asset class Sharpe Ratios low (remember, if all Sharpe Ratios are lower, risk parity is still valid).  

Even if conditions 1), 2), and 3) held, i.e. bonds look expensive over a tactical horizon, risk parity isn’t necessarily invalid…refer back to criticism #3’s response.  Before leaving this section, it is important to note that risk parity neither “overweights” nor “underweights” any one particular asset class.  Risk parity equalizes risk across asset classes because “risk equalization” produces the highest portfolio risk-adjusted return when individual asset class, risk-adjusted returns and diversification benefits are identical. 

The Bottom line for Investors & Managers 

When assessing strategic asset allocation approaches such as risk parity, investors should resist the temptation to focus on short-run, realized performance and/or tactical market views. It is imperative to view strategic asset allocations through a long-run, prospective lens. Does this mean strategic asset allocation approaches are immune to scrutiny?  No.  Pay close attention to the implicit/explicit assumptions justifying the competing strategic asset allocation approaches.  For example, in the case of risk parity, is the identical asset class Sharpe Ratio assumption reasonable when compared to the accuracy of the assumptions used in competing strategic asset allocation approaches?  Given the difficulty in explicitly forecasting asset class expected returns, risk parity is not a bad starting place – it avoids the “garbage in, garbage out” criticism associated with classic mean-variance optimization.

For risk parity managers, the advice is the same: don’t be discouraged by short-run poor performance, but be humble…make sure to continually question the veracity of the assumptions providing the foundation and justification of your particular strategic asset allocation approach relative to others.  

Peter Hecht is Managing Director and Senior Investment Strategist at Evanston Capital Management. Prior to joining Evanston Capital Management, Mr. Hecht served in various portfolio manager and strategy roles for Allstate Corporation’s $35 billion property & casualty insurance portfolio and $4 billion pension plan. Hecht also served as an Assistant Professor of Finance at Harvard Business School. His research and publications cover a variety of areas within finance, including behavioral and rational theories of asset pricing, liquidity, capital market efficiency, complex security valuation, credit risk, and asset allocation.   

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