Busting the risk parity misconception
James Williams (pictured) explores why risk parity should not be viewed as a hedge fund substitute.
Despite becoming an important component of investors’ portfolios, there are still some common misconceptions as to how risk parity strategies should be viewed, and used.
Risk parity is a strategy that aims to diversify risk across global, liquid asset classes in order to create a portfolio that is not reliant on any single asset class for long-term performance. Over the years, different flavours of risk parity have emerged. One of the reasons for its appeal is that classic mean-variance optimisation relies upon expected risk and return estimations.
Expected returns are practically impossible to estimate. However, volatilities are much easier to estimate. This has led to investors turning to risk parity, which does not rely on expected return inputs.
“Investors have been grossly overweight equity risk, and risk parity is a way for them to reduce concentration in equity risk without reducing overall risk (otherwise they won’t achieve their target returns). I think that has been one of the primary motivations behind investors turning to risk parity strategies,” says Michael Mendelson, Principal and portfolio manager of AQR’s risk parity strategies.
Peter Hecht is Managing Director at AQR. Previously, when he engaged with institutional investors as to why they were looking at risk parity, the common response went along the lines of: “I’m exploring whether a risk parity strategy could be a substitute or complement to my overall hedge fund programme”.
“They were generally viewing risk parity through the lens of a hedge fund programme. However, risk parity’s characteristics are very different from those of hedge funds. After all, hedge funds involve shorting, they are dynamic, they try to offer differentiated, idiosyncratic returns and lean heavily on proprietary expected return views.”
“On the flipside, when I think of plain vanilla risk parity (there are various flavours) I think of it as a long-only, static risk allocation to various public market betas. To me, comparing strategic risk parity to hedge fund strategies is like comparing apples to oranges. A strategic risk parity fund isn’t a true hedge fund substitute. Instead, its role in a portfolio can be seen as separate and distinct,” explains Hecht.
As such, the first misconception is that risk parity is a hedge fund strategy and can be incorporated into one’s alternative allocation bucket. It is not. Rather, it should be thought of as a rival to other public market, long-only strategic asset allocation approaches.
“When we first started managing risk parity strategies almost 11 years ago,” says Mendelson, “at that time there was no natural home for it in an institutional portfolio, so it commonly ended up going into the alternatives allocation. We never thought of it as a hedge fund strategy, we always thought of it as a beta fund. There is no notion of hedging, although there is a modest use of leverage. It was only in later years that investors started having a carve-out allocation to risk parity.”
A second misconception is that risk parity can deliver an optimal portfolio with the highest Sharpe Ratio. When Hecht refers to ‘optimal’, what he is referring to is a portfolio that maximises expected excess returns (over and above the risk-free rate) for a particular level of volatility (risk).
He explains that the only way for risk parity to deliver an optimal portfolio is if each asset has an identical Sharpe Ratio, and also that each asset has identical pairwise correlations. Most explanations of risk parity, however, ignore the importance of the equal correlation assumption, or incorrectly state that correlations must be zero.
AQR’s approach to risk parity strategies has been to minimise the assumptions and take a view that the Sharpe Ratios of different assets are broadly similar, and that the risk weightings should also be roughly the same. Mendelson says that while one can apply some finer points to make the portfolio more optimal, it requires heavier risk weighting assumptions, ie. which assets have a higher Sharpe Ratio and which have a lower Sharpe Ratio?
“We wanted to regard stocks, bonds, commodities, credit etc, on a similar Sharpe Ratio basis, and equal weight them in the portfolio. We don’t know what the perfect portfolio is; if we did we would create it. We made the assumption that while we cannot exactly know the Sharpe Ratio of each asset, they are more similar than they are different so the allocations of risk should also be more similar than different,” explains Mendelson.
A third misconception is that risk parity concepts such as risk balancing are something new. They are not, and are merely a version of modern portfolio theory first expressed in the 1950s.
Classic mean-variance portfolio theory involves firstly identifying the highest Sharpe Ratio portfolio using a form of risk balancing to achieve the lowest possible volatility for a given level of expected excess return; and secondly, using leverage (or T-bills to deleverage) to hit a target return.
The reason why, in recent times, traditional portfolio construction has involved a 60:40 weighting to stocks and bonds, with up to 90 per cent of the risk budget held in stocks, is because institutional investors have tried to implement modern portfolio theory with one huge constraint: no leverage.
“If you actually apply modern portfolio theory without that constraint, it looks very different from a 60:40 portfolio. You will end up with something that more closely resembles risk parity,” explains Hecht.
A final misconception is that strategic asset allocations like risk parity should be fair game for criticism based on short-term tactical views.
As mentioned earlier, risk parity comes in different flavours. Most risk parity assets tend to be held in the strategic version of risk parity, estimates Hecht, which is static in its (balanced) risk allocation, versus the tactical version which overlays some short-term and medium-term views.
Strategic risk parity portfolios tend to have large dollar allocations to low risk assets, such as fixed income. Given the perniciously low interest rate environment, this property of typical risk parity portfolios has been criticised by investors, but in Hecht’s view, this is misguided.
“A strategic asset allocation, of which I believe risk parity is one such example, is all about forming a portfolio based on a long-term horizon. If I had to hold this portfolio for the next 100 years, what would be my optimal allocation? There are no tactical views; that is the definition of a strategic asset allocation.
“What concerned me is that people would criticise an SAA based on some short-term tactical view. It makes it seem like a criticism of risk parity when it’s really just saying that if you have a strong tactical view and you think you are right, you should always deviate from your strategic view. That’s not something that you need to link to risk parity. That’s applicable to any SAA approach.
“If you have a tactical view that deviates from the underlying assumptions of your strategic long-term view you should change your portfolio weights in a way that reflects that short-term view,” explains Hecht.
Mendelson adds that today’s low yield environment is a manifestation of low risk free rates and that this affects everything an investor holds, not just bonds: “You can think of your total return as the risk-free rate plus an excess return. We have very little reason to believe excess return for holding bonds is any more challenged than it is for stocks or anything else. The optics are more obvious in bonds but that low risk-free rate is just as embedded in stocks.”
The point of risk parity is that it makes no attempt to try and predict where markets are going to go and in that sense it remains an attractive proposition to investors. Regardless of the global macro events that shape markets, the answer, says Mendelson, is to build a good portfolio and be diversified.
Hecht concludes: “It’s not about being able to try and predict what the Bank of Japan is going to do, or what the consequences of Brexit might be, it’s about being able to do things better than what is already reflected in current market prices.”