Asset AllocationMay 9, 2013

Why Risk Parity is Like Goldilocks

<em>Not too much information, not too little – risk parity’s requirements sit right in the middle.</em>

Reported by Featured Author

(May 9, 2013) — A risk parity approach will beat both active and passively managed portfolio more than 50% of the time under any conditions due to its Goldilocks-type nature, a new paper has claimed.

“Forming risk parity portfolios does not require as much data and as many sophisticated tools as forming other portfolios, such as the tangency portfolio embraced by standard portfolio theory. But it does require more data than the equally weighted portfolio. Yet it consistently outperforms both,” a paper by three proponents of the approach claims.

Gregg S. Fisher, CIO at investment firm Gerstein Fisher, Philip Z. Maymin, assistant professor of Finance and Risk Engineering at NYU-Polytechnic Institute in New York, and Zakhar G. Maymin, head of research at Gerstein Fisher Research Center have published a paper entitled “Risk Parity Optimality”.

In it they claim: “Risk parity may represent a ‘sweet spot’ of heuristics where any more or any less knowledge would seem to harm performance.”

The trio set out to prove that under (rather imprecise) “general conditions” the “probability of risk parity beating any other portfolio is more than 50%.”

The paper measures a risk parity portfolio on a Sharpe ratio basis and finds under “some natural assumptions” – which it also leaves rather vague – “it will do better than any other portfolio construction method under the worst possible combination of true expected returns.”

Last month, research from investment consultant Redington showed the approach won out as the best option for risk adjusted returns over the last three-year and 12 month periods.

The Gerstein Fisher paper sets out a range of theoretical formulae and charts to support its findings and concludes that although risk parity has intermittently underperformed other portfolio construction techniques, it is perfectly balanced to offer consistent impressive risk-adjusted returns.

The approach has found both favour and derision from investors either side of the Atlantic. A flurry of new product launches in Europe has pushed the debate on further – and raised concerns about a possible bubble forming or investors getting into a new trend they do not fully understand.

To read the Gerstein Fisher paper, click here.