(August 22, 2012) — Risk parity — the investing strategy that focuses on balancing risks rather than allocating of capital — is a portfolio construction methodology that has as much if not more relevance at a total fund level than it has as an investment product.
This sentiment comes from Bob Prince, the co-chief investment officer of Bridgewater Associates, the world’s largest hedge fund, which he and others argue was the originator of a risk parity strategy through its All-Weather fund. Prince notes that risk parity should be the basis of any strategic allocation. “When you think about what a strategic allocation is, it is your agnostic starting point. Alpha is then produced by tactical deviations around that. Risk parity is the mix of assets an investor would want to hold absent a view of markets.” He continues: “That’s what Bridgewater’s All-Weather approach is all about, a balanced strategic asset allocation that delivers reasonable results over time, no matter what the world throws your way.”
The alternative investment approach is the traditional 60/40 asset allocation, which takes a concentrated position in equities and is exposed to sustained economic weakness, Prince adds.
Prince’s comments also jibe with a newly published paper by Australia-based Round Tower Solutions, which notes that allocations to risk parity products will have minimal impact on the fund’s outcomes unless similar portfolio construction techniques are adopted at a total fund level. Furthermore, Round Tower asserts that false expectations about diversification most often result in increased risk taking through leverage. “It is important to guard against this risk, though some leverage will be required,” the paper continues.
From a theoretical perspective, the paper outlines a number of issues that investors should consider when deciding to implement a risk parity allocation:
1. Risk premiums.
2. Standardizing the measurement of risk — many participants note the issues associated with applying volatility to non-normal distributions and yet most risk parity methodologies still use volatility to scale risk levels.
3. Non-traditional approaches may be superior because they are still not the norm. Behaviorally, if all investors were to switch to a risk parity methodology, Round Tower notes that it would question whether the strategy could maintain its comparative advantage.
“It is difficult to find an asset consultant who does not like risk parity though the approach does have its skeptics who correctly note that much of the difference in past performance between traditional 60/40 portfolios and risk parity portfolios is driven by the larger allocation to bonds (which have performed strongly over the last 30 years),” the firm concludes.
Despite the growing embrace of the concept of risk parity — particularly following the financial crisis — skeptics have also been vocal. In May, for example, a whitepaper published by Hewitt EnnisKnupp asserted that the benefits of a risk parity strategy for a total portfolio are limited. According to the paper by Michael Sebastian, a partner at the consulting firm, risk parity investors are often putting themselves at a loss for ignoring equities in extreme favor of fixed-income.
Meanwhile, last year, Ben Inker, head of the asset allocation group at Boston-based GMO, told aiCIO: “It was largely inadvertent in the start, being anti-risk parity. I seemed to have the field largely to myself. I’ve never felt the urge to write against other products — and I did not do it to be controversial. We have some very serious concerns with risk parity portfolios…Volatility is not inherently a risk. Only when there is leverage in investments is volatility unquestionably a risk.”
In response to such criticisms, Bridgewater’s Prince says that such criticisms of risk parity are largely critiques of leverage, and have not held up well over time. “The assumptions of the All-Weather approach are very basic: risky assets require a risk premium above cash, and the pricing of asset classes reflects discounted cash flows which are affected by the economic environment. Also, risk parity is not a bond portfolio — a bond portfolio would be another concentrated portfolio with vulnerabilities to inflation and rising interest rates. A risk parity approach neutralizes yourself to any particular asset class or economic environment. You just need enough bonds to create balance.”
Related article: Risk Parity Opinions, Crowdsourced