Asset AllocationApril 18, 2013

Risk Parity – the Sharpe Option

<em>Risk parity divides opinion like no other investment option – but (past) performance cannot lie.</em>

Reported by Featured Author

(April 18, 2013) — Risk parity won out as the best option for risk adjusted returns over the last three-year and 12 month periods, research has shown.

The approach of allocating to a portfolio of assets that are equally weighted on a risk basis beat a range of mainstream and alternative assets, investment consultants Redington found.

In the 12 months to the end of March this year, risk parity strategies made excess returns of 15.54%, which beat the closest contender – high yield European debt – by almost four and a half percentage points.

On a Sharpe Ratio basis, which looks at the return made for the risk taken, risk parity strategies took the top spot in this time period with a rating of 3.32. The closest runner up was US high yield debt, with a score of 2.71.

The worst performing asset class, on both measures, was emerging market equities. Over the past year, they made excess returns of 1.56%, but only earned a Sharpe Ratio of 0.1.

Over a three-year period to the end of last month, risk parity again outperformed, but more moderately.

Excess returns for the approach reached 12.25%, with a Sharpe Ratio of 1.71. In second place, in terms of excess returns, index-linked UK government bonds produced 10.41% but fell behind emerging market debt hard currency on a Sharpe Ratio basis with a score of 1.46.

Over a five-year period, returns were dampened further, with risk parity slipping to fifth place on an excess return basis and fourth in terms of Sharpe Ratio.

Recently, market participants have questioned whether risk parity has been oversold and considered the “bubble” bursting.

Kevin Kneafsey, senior advisor, multi-asset investment and portfolio solutions at Schroders, said: “The part of the bubble I think you are right to worry about is the product push in this space and the lack of thought behind many of them. The idea of better balancing risk across the key drivers of asset returns makes a lot sense. Blind applications of equal risk to assets can be quite dangerous and lead to very poorly balanced risk exposures. It is these risk exposures that ultimately drive the asset returns and determine the portfolio risk.”

For an in-depth investigation on how the approach is spreading across Europe, see aiCIO magazine published later this month. For the full Redington paper, click here.