Gregory D. Houser, CFA, CAIA
Senior Vice President, Capital Markets
A risk parity portfolio seeks to better diversify portfolio investment risks, so that each risk taken has a material impact on the portfolio, but does not dominate the overall investment risk.
FOCUS TOPIC: RISK PARITY - THE TRULY BALANCED PORTFOLIO?
Risk Parity - The Truly Balanced Portfolio?
As with any traumatic event, including traumatic events in the economy and investment markets, the natural human reaction is to seek means to avoid recurrence. After the 2008 financial crisis, investors have sought to better position portfolios to weather such a period of turmoil. These attempts run the gamut from reactively selling equities and hoarding gold to rethinking the investment risks taken at a time when investment risk premiums were extremely low. Most investors’ portfolios are dominated by equity risk, and when the stock market crashed with this decade’s hundred-year-flood, all risk assets declined, but investors’ equity allocations created some of the most substantial losses. In an effort to reduce the negative impact of an equity market decline on the total portfolio, investors have given increased attention to risk parity portfolios, which balance and diversify the investment risks within a portfolio in an effort to reduce downside risk. While risk parity is not a new approach, recent market turmoil has driven some investors to reconsider the strategy. This Focus Topic looks at what risk parity portfolios are, the theory behind risk parity, the use of leverage in risk parity portfolios, how risk is targeted in risk parity portfolios, and implementation concerns, including implementation in a low yield fixed income environment.
Risk Parity Primer
Equities, given their relatively higher long-term historical rates of return, have traditionally played a significant role in investors’ portfolios in order to meet the desired return target. Equities, however, also bring a heightened level of volatility. As a result, an investor with a moderate allocation to equities introduces a level of equity risk not commensurate with the risk of other allocations. The impact of the substantive equity allocation is that investor is not truly diversified, since equities are riskier than bonds the portfolio dominated by equity risk. This is illustrated in the following charts. This is the epitome of violating the old adage “not putting all your eggs in one basket” with equities providing the vast majority of the portfolio’s risk.
A risk parity portfolio seeks to better diversify portfolio investment risks, so that each risk taken has a material impact on the portfolio, but does not dominate the overall investment risk. This balanced approach to risk taking is employed to mitigate the potential for disastrous consequences if the assets tied to a risk, for example global equities, were to plummet in value, as was the case in 2008. Effectively, a risk-based approach to portfolio construction is used to equalize the risks taken in the portfolio. The balanced risk approach results in a larger than what is typically normal allocation to fixed income instruments for reasons that are explained later. Once the balance of risk is established, and because the large fixed income allocation leads to lower expected returns, leverage is introduced to increase the overall risk/reward profile of the portfolio, but without allowing one risk factor to dominate the portfolio. Consequently, a diagram of the investment allocations and corresponding risks taken in a risk parity portfolio would appear as the following:
In sum, characteristics contrasted between traditional portfolios and risk parity portfolios are as follows:
Risk Parity Theory
Risk parity differs from traditional mean variance optimization in that risk parity seeks diversification of risk, while mean variance optimization seeks to minimize risk of the total portfolio, irrespective of any consequential risk concentration. Thus, risk parity takes a risk budgeting approach to building portfolios versus an optimizer’s risk minimization approach to building efficient portfolios, the portfolios that provide the greatest level of return per unit of risk, as measured by the volatility of those returns (standard deviation). The curved line in the following chart illustrates the efficient frontier of portfolios; all other combinations of assets lie under the efficient frontier. While we recognize standard deviation of returns is not a perfect measure of risk, it is an important measure in assessing the risk of an asset and serves as a suitable proxy for risk in this illustration.
Investors seeking a high level of return have two choices, increase expected return by either investing in riskier assets or by adding leverage to less risky assets. Finance theory tells us that once the most efficient portfolio is identified along the efficient frontier, an investor should theoretically be able to borrow or lend at or near the risk-free rate to increase or decrease risk and return commensurately. This allows the investor to move along the capital allocation line by leveraging the optimized portfolio, in order to increase returns with a more constrained level of risk relative to any efficient frontier portfolio. The capital allocation line is a graphic representation of the opportunity to increase risk from the risk-free interest rate, the point at which the capital allocation line meets the Y-axis, to the point tangent with the efficient frontier, the optimized portfolio, and beyond with leverage. Securing leverage (or providing lending) for the optimized portfolio to move up (or down) the capital allocation line should theoretically allow an investor to meet their target risk and return.
The risk parity portfolio will not lie on the efficient frontier as the optimized portfolio will, but the risk parity portfolio will generally lie near the efficient portfolio on the risk return spectrum, as illustrated in the previous chart. The reason for the portfolios’ placements is the somewhat similar asset class allocations, including a material allocation to fixed income attributable to fixed income’s historically lower relative volatility. Due to an optimized portfolio’s sensitivity to volatility and correlation inputs, the optimized portfolio may have a lower total risk level than a risk parity portfolio; however, the risk will be more concentrated than the diversified approach of risk parity.
Most investors do not invest in the optimized portfolio due to the low expected return, nor are conservative investment portfolios typically leveraged explicitly to move along the capital allocation line. Instead, the portfolio is allocated to riskier assets in order to reach a given level of return to achieve the investor’s objectives, thus moving an investor’s portfolio along the efficient frontier, and taking substantial equity risk.
As previously mentioned, in order to meet the return needs, the portfolio is leveraged. This allows the investor to move along the risk parity line, much like leveraging the optimized portfolio along the capital allocation line, in order to increase returns with a more constrained level of risk relative to the efficient frontier portfolio.
The application of leverage, especially after the largest financial crisis since the Great Depression, is often met with raised eyebrows. One should remember, however, that the use of leverage was not the root cause of the financial crisis; instead the large-scale inadequate management of leverage and poorly underwritten loans to those with an inability to pay were the root causes of the crisis.
Another common misconception is that the strategy is purely a leveraged fixed income strategy. While the strategy does typically include both a large fixed income allocation and the use of leverage, the strategy is not one of simply leveraging the bond allocation. Instead, the overall portfolio is leveraged to maintain a balanced risk approach. Some argue that the equity allocation is implicitly leveraged by the corporate balance sheets of the companies in which the equity is owned and therefore, should not be levered. In a risk parity context, however, the equity allocation is reduced, thus reducing the implicit leverage from the volatile allocation in favor of leveraging the risk diversified portfolio.
Instead of targeting a given level of return based on market expectations, which the peaks and valleys of returns in the following charts illustrate is notoriously difficult, risk parity begins with expected risk (volatility) and builds the portfolio around risk expectations. Market volatility tends to have greater predictability over time relative to market returns due to the tighter relative range within which standard deviation historically fluctuates. Despite periods of relative stability in market volatility, volatility can increase substantially over a short time period. One need only to look at the rise and fall of markets in the technology bubble, clearly illustrated in the following chart. More recently, volatility as measured by the VIX spiked above 80, four times the average near 20, at the peak of the 2008 financial crisis. The fluctuation of volatility, in both equity and fixed income markets, illustrates that risk is not stable and requires strong active management of a risk parity strategy to adjust to changing market conditions. This active management is not simple and comes at a cost. One should also understand that risk parity management requires consideration of risks beyond volatility, including liquidity risk, changing correlations, and borrowing risk to name just a few. Strong management is required to address these issues as well.
While on the surface risk parity may seem intuitively simple, the devil is in the details. Recent market turmoil clearly illustrated that excessive leverage can turn small declines in asset value into tremendous losses. Timing and liquidity are two key elements impacting the degree of portfolio suffering in the event of a market downturn. Losses could be easily exacerbated by forced selling at the worst time in order to service the debt. Asset liquidity must also be managed, for in the event there is a need to liquidate assets due to debt service, illiquid assets would likely be sold at fire sale prices. These potential negative impacts illustrate the need to maintain adequate cash balances. Additionally, a mismatch in the duration of the borrowing and the investment portfolio is a risk that must be managed. If the borrowing is done on a short time horizon and investments are made in longer duration assets, the rollover risk of a move in short-term rates above the long-term investment yield could harm the portfolio.
Understanding that leverage must be managed and the risk exposures balanced indicates that something more than a buy and hold approach is required. Simply taking a traditional allocation of stocks, bonds, real estate, commodities, and perhaps hedge funds and private equity investments, and using a line of credit to increase the portfolio position without strong oversight would be a risk laden approach to implementation. The use of futures and other derivatives to gain market exposure and manage both leverage and liquidity may provide a stronger solution. Futures naturally provide leveraged exposure, requiring only a portion of the exposure in cash margin, allowing the investor to gain the desired level of market exposure while maintaining adequate cash balances. Derivatives have also been painted in a negative light following the financial crisis, but like leverage, the prudent use of derivatives can be beneficial to a portfolio.
There are other implementation concerns that go beyond an increased risk of financial loss with the use of leverage. Changes to the costs of leverage also impact the effectiveness of the strategy. If the cost of borrowing increases materially, the benefits of leverage dissipate, as there are increased costs to managing the portfolio. The risks that come with leverage illustrate the need for strong portfolio oversight. Proponents of risk parity have wisely pointed out that the leverage risk is controllable, unlike the over abundance of equity risk most investors carry in their portfolios.
Finally, as mentioned previously, markets move, volatility levels change, and the portfolio must be rebalanced in a risk context. For example, if the volatility of interest rates were to increase, the allocation to interest rate risk would be reduced. Such rebalancing also occurs with equity risk, inflation risk, etc. This reality also works to the advantage of a risk parity portfolio. Markets generally see increased volatility in periods of market distress. Thus, a risk parity approach would typically reduce the allocation to interest rates or equities in the event momentum turns negative either of those allocations. Rebalancing, therefore, should aid the risk parity portfolio in times of distress, but again strong active management is required. As with any rebalancing, the frequency of rebalancing is offset by the transaction costs.
Fixed Income Yields
Many have questioned the prudence of a material fixed income allocation in the presence of historically low yields and commensurately adding leverage to a portfolio with this positioning. The concerns are exacerbated by concerns of future inflation, which would harm bondholders. The concerns would carry greater weight if the allocation to fixed income securities were simply a position in U.S. Treasuries. A risk parity portfolio, however, allocates in a diversified manner to both interest rate risk and credit risk. This would include positions in sovereign bonds, many of which carry higher yields than U.S. Treasuries. Additionally, positioning in U.S. Treasury Inflation Protected Securities (TIPS) would offset the inflation risk of Treasury holdings. One cannot forget the other allocations in the portfolio, which should perform well in the event bond returns were declining (yields rising). Alternatively, in the event of a double-dip recession that led risk sectors lower, the increased positioning in fixed income should likely be welcomed.
Implementing a risk parity strategy requires strong portfolio management capabilities and continuous oversight. Many of the implementation concerns must and can be managed in order to reduce the potential for unintended consequences of using leverage and building the allocations.
Additionally, investors finding the approach compelling must ask themselves if they are willing to make a commitment to a more defensive strategy. In periods of market euphoria, a risk parity strategy will lag the U.S. equity markets, putting pressure on many investors to follow the herd and requiring strong belief in the strategy over the long term. One only needs to think back to the fortitude one required to avoid increasing a portfolio’s equity allocation in the late 1990s or rushing to cash in early 2009. While both reactions were thoroughly punished for following the herd, investors had a difficult time resisting the pressures.
Risk parity may not be immediately practical for all investors, but the theory and strategy of risk parity is worthy of further consideration. The primary significance of the approach, understanding the dominance of equity risk in most portfolios, is an important message to comprehend and incorporate into investors’ allocations regardless of direct adoption of the strategy. A key fundamental aspect of risk management is first understanding the risks one is taking. The risk parity approach compliments the FEG investment philosophy of comprehending the underlying risk drivers in a portfolio. The overabundance of U.S. equity risk in investor portfolios is a risk we have sought to reduce through various means, from hedged equity to real asset investments. Risk parity, therefore, fits well with our investing principles. Some aspects of the strategy, however, give us pause and reinforce the need for strong due diligence and portfolio oversight.