Risk Parity Skeptic Says Leverage Has Limits
(May 30, 2012) — The benefits of a risk parity strategy for a total portfolio are limited, a whitepaper published by Hewitt EnnisKnupp states.
The investing framework of risk parity incorporates an often undue amount of leverage, which often provides limited risk and return benefits relative to traditional portfolios, according to the paper by Michael Sebastian, a Partner at the consulting firm.
The concept of risk parity has skyrocketed in popularity as investors leverage the fixed-income side of their portfolios in hopes of greater future returns, but Sebastian urges investors to not shut their eyes to equities. “Equity dominates portfolio risk for a good reason — its role is to deliver returns on risk, and has done so over the long term.”
According to the paper, the primary role of investment-grade fixed income in an institutional total fund is risk reduction. Yet leverage, which is an intrinsic part of a risk parity approach, distorts that property.
Sebastian continues: “We believe that the current environment offers a relatively strong outlook for equities, and modest returns for bonds.”
In other words, according to Sebastian, risk parity investors are often putting themselves at a loss for ignoring equities in extreme favor of fixed-income.
Sebastian is not completely skeptical of the benefits of a risk parity approach, however, claiming that risk parity strategies are appropriate for an opportunistic or alternatives allocation that are designed for strategies that don’t fit well in a traditional asset allocation framework, “particularly at higher levels of targeted volatility”. Risk parity, then, should be considered for investors who are faced with extremely high levels of volatility and should be implemented at a modest level when needed to control risk, Sebastian recommends.
Sebastian is not alone in his assertion that with risk parity, leverage has limits. 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.”