(December 8, 2011) — “To invest based on risk parity, you must have an accurate measure of risk.”
That is the advice championed by Damon Krytzer, a trustee at the San Jose Police and Fire Retirement Plan and managing director of Waverly Advisors.
“Investors in a market environment driven largely by binary risk-on/risk-off decisions rather than by measurable fundamentals are faced with a choice,” a newly released report by Krytzer asserts. “Those empowered with a dynamic decision-making process can invest more tactically, targeting multiple sources of alpha and perceived inefficiencies. The point here is to develop a risk budget and to size and diversify positions opportunistically within an otherwise strategic allocation. However most allocators (e.g., a pension CIO) do not have this flexibility and must develop a long-term methodology to meet their targeted goals. One alternative presented is that of Risk Parity; to develop a constant and equal weighting to asset classes based on risk rather than allocating based on notional dollars.”
According to Krytzer, weighting portfolios based on risk contribution is ideal compared to weighting portfolios based on dollars invested.
The report continues: “As I review risk parity proposals, the first obvious point is to understand the meaning of risk itself. Are we referring to tail risk and shock events, standard deviation of returns, or to measured volatility? All require very different actions. Most fiduciaries are concerned with portfolio volatility, and here the choice of measurement criteria is key. First, we must decide whether to measure relative historical or implied volatility, or possibly a blend of the two. Either way, trust me – a professional can be absolutely correct on the direction of volatility, but extremely wrong on execution based on tenor or measurement. Simply put, defining the volatility of US equities as ‘low’ or that of ten-year rates as ‘high’ is both art and science combined.”
Krytzer expressed his ideas about misperceptions behind dynamic asset allocation and risk parity strategies with aiCIO in October. Dynamic asset allocation and risk parity strategies are often based on incorrect assumptions, according to Krytzer, who noted that while he likes the idea that funds are using risk contribution as the focus rather than return distribution, their investment strategies should be based on different metrics. “These strategies assume that the asset allocation mix doesn’t change over time — with the false assumption based on diversification among asset classes rather than risk factors,” he said, noting that focusing on risk factors as opposed to asset classes is a more appropriate emphasis.
He added: “The revised approach would be better because you’re basing decisionmaking on actual underlying drivers that move asset classes — as opposed to asset classes that may be more highly correlated in different markets.”
According to many in the industry, dynamic asset allocation and risk parity strategies have gained heightened attention because of the desperation among investors to achieve success in a difficult market environment. “Returns have been awful. People are scared, and markets aren’t reacting the way people would like. So, you turn to something that seems like a systematic way to manage a challenging market,” Krytzer said, highlighting his belief that these models have underlying problems in the way many of them are currently applied and executed.
Krytzer’s assertions questioning the assumptions behind investment strategies follow recent comments made by Mark Baumgartner, Director of Asset Allocation and Risk at the $11 billion Ford Foundation, who sat with aiCIO earlier this year to discuss the market environment, ‘true’ diversification, and the end-goal of Foundation investing. “You have to make sure you are diversifying with risk factors, not just asset classes,” he asserted. “All investments have fat tails, all markets are irrational at times. However, something that is not widely acknowledged: You can reduce the impact of fat tails with good portfolio construction and ‘true’ diversification,” he said.
The concept of risk parity has also encountered scrutiny in a research paper by Marlena Lee, vice president at Dimensional Fund Advisors, which claimed that over the last 81 years, risk parity portfolios have not produced higher Sharpe ratios than the traditional 60/40 balanced approach.
The report, titled “Eight Decades of Risk Parity,” asserts: “This paper uses over a century of returns from nineteen countries to conduct an out-of-sample test of whether risk parity delivers superior risk-return tradeoffs. The results show that previously documented risk parity benefits are sample specific. Over the last eighty-one years, risk parity portfolios do not have higher Sharpe ratios than 60/40 balanced portfolios.”
According to Marlena, while proponents of risk parity claim the investment strategy is an alternative approach to asset allocation that promises better risk adjusted returns than traditional 60/40 balanced portfolios, the “promise is deceptive.” The reason, according to the paper: “Out-of-sample results show that the touted benefits of risk parity only appear in the last thirty years during a period of falling inflation and interest rates. Because bonds did unexpectedly well over this period risk parity portfolios also benefit due to their heavy bond allocations. Unsurprisingly, risk parity does poorly from 1956 to 1980, a period of rising inflation. From 1930 to 1955, a period of volatile but non-trending inflation, risk parity yields Sharpe ratios that are similar to traditional 60/40 portfolios.”