Using Sharpe ratios—the bang for the buck from an asset—rather than looking purely at risk in a portfolio is a surer way of getting consistent positive returns, analysts at UBS have claimed.
In a paper entitled Much better than risk parity: Sharpe parity, Stephane Deo and Ramin Nakisa reiterate their concerns with the original strategy and set out what they think is a new and better option.
“Fundamentally risk parity completely ignores return and focusses only on risk,” Deo and Nakisa, UBS. “Fundamentally risk parity completely ignores return and focusses only on risk,” the authors said. “If we have a universe of two assets, one of which is trending downwards with low volatility and the other trending upwards with high volatility, risk parity would allocate the majority of capital to the falling asset. Managing risk is not managing return.”
Deo and Nakisa also criticised risk parity for solely using volatility as a measure of risk for credit.
“One must also consider the illiquidity of corporate bonds to be a risk, but again this is not captured by price volatility. For this reason incorporating credit, particularly high yield credit, into a risk parity framework is very dangerous,” they said.
Instead, investors should consider the by-product of taking risk—the return—when constructing a portfolio.
“If asset X has a Sharpe ratio of two it means that we have two units of return for a unit of risk, while asset Y with a Sharpe ratio of one gives us only one unit of return for the same amount of risk. In that case we construct a portfolio with the weight for asset X being the double of the weight of asset Y. You can also think about it as having the same risk premium for each asset class,” the paper said.
Although this strategy penalizes the weight of each asset if it is more volatile, it does not consider diversification at all, the UBS team said, adding that they might expect this strategy would have higher volatility than the maximum Sharpe approach, which does consider diversification.
However, they found their Sharpe parity approach did not show any strong preference by asset—unlike risk parity, which has a strong inclination to fixed income—and “intuitively this makes sense”.
“Theory tells us that the return of an asset should be proportional to its risk, so if we use the ratio of return over volatility, we should have equal weighting for each asset,” they said. “And indeed, this seems to be pretty much what we get.”
This new approach takes into account recent performance of an asset and as such has a bias towards a momentum strategy.
And how would Sharpe parity have performed when risk parity was hit during 2013’s “taper tantrum”? Better, the authors said.
“We find that Sharpe parity performs well in terms of limiting the drawdown. Only the minimum variance portfolio, which is specifically designed for minimising risk, is better. Interestingly though, if we look at the time needed to recover from the drawdown, Sharpe parity comes as best in class,” they said.
The full paper can be downloaded here.
Related content: CIO’s 2013 Risk Parity Investment Survey & When Risk Parity Goes Wrong