Risk parity is an approach to portfolio construction where capital is allocated such that the risk associated with each asset is exactly the same at all times. The simplest version of risk parity directly rebalances the portfolio allocation such that the weight of each asset multiplied by its volatility, i.e. the risk budget, remains constant over time and is equal to the risk budget allocated to all other assets. Consequently, in a risk parity portfolio, the assets with the lowest risk, traditionally government bonds, have a much bigger weight than the riskier assets such as equities.
It is not difficult to demonstrate that a risk parity portfolio is the optimal mean-variance portfolio, provided that the expected Sharpe ratio for each asset in the portfolio is exactly the same and that all correlations between asset returns are equal. Indeed, the creators of risk parity defend the view that in the long term, investors should in fact expect a similar compensation for risk from all asset classes, claiming that, over time, the Sharpe ratio for any asset class should fall to somewhere in the range of 0.2 to 0.3.
PORTFOLIO COMPOSITION SHIFTS WITH VOLATILITY
The performance of a risk parity portfolio can be explained first by the choice of allocation of risk, i.e. the decision to allocate the same risk to all assets, and second by the rebalancing required to keep the risk allocated to each asset constant over time. Since the volatility of asset returns is not constant, it is necessary to increase each asset weight when its volatility is low and decrease it when the volatility is high.
In a recent paper, we investigated the contribution of this rebalancing to the performance of risk parity strategies. We found that the rebalancing adds substantial value for risky assets, but not so much for government bonds. For equities and other risky asset classes, the average returns tend to be poor, even negative, in periods of high volatility and positive and strong when volatility is low. But this is not the case for government bonds. Volatility of bond returns does not vary that much over time and there is no strong negative relationship between volatility and government bond returns, as there is in the case of equities. So rebalancing to keep the risk constant does not add much value in the case of government bonds.
One of the consequences of significantly overweighting government bonds, traditionally the asset class with the lowest risk, is that the final risk of the portfolio is typically much lower than that of the typical asset allocation portfolio which invests 40% in government bonds and 60% in equities. Therefore, although risk parity portfolios should result in higher risk adjusted returns if the Sharpe ratio of each asset class is the same, they tend to have much lower risk than the traditional portfolio and may earn lower returns in the long term.
LEVERAGING UP TO INCREASE THE RETURN POTENTIAL
For this reason, risk parity managers tend to use leverage. They simply borrow to invest more than the initial capital allocation. For every EUR 100 allocated to a risk parity fund, portfolio managers for instance borrow another EUR 100 and invest all the capital, in this case EUR 200, in the risk parity portfolio. This level of leverage is not uncommon. The advantage of using leverage in this way is that the final EUR 200 portfolio is twice as risky as the original EUR 100 risk parity portfolio, and can thus be expected to earn twice the excess returns over money-market rates.
Risk parity strategies have been quite successful in the last 20 years when applied to multi-asset portfolios investing in government bonds from the US and Europe, credit, equities and commodities. That is perhaps not surprising. In the last 20 years, government bonds have delivered stellar risk-adjusted returns. US and European government bonds had Sharpe ratios closer to 0.8 than the 0.2 suggested by the creators of risk parity. That means the returns generated by government bonds were four times higher than they expected.
It is not surprising that a leveraged portfolio overweight government bonds did much better than a traditional asset allocation portfolio, which is overweight equities and has a risk allocation to equities of about 90%. The last two decades were certainly not easy for equities, with the 1999-2003 internet bubble and the financial crisis in 2008. Only now is the Sharpe ratio for equities returning to 0.2 – 0.3 and that’s if we include the last three years with a bull market.
HAS THE ‘GOVERNMENT BOND WELL’ DRIED UP?
This is one problem of risk parity – the fact that it completely ignores valuation risk. If the Sharpe ratio of government bonds is to converge towards 0.2 to 0.3, we must now expect rather poor risk-adjusted returns to compensate for the last 20 years of stellar performance. And this is not improbable. One of the drivers of the very generous risk-adjusted returns of government bonds and other forms of fixed income investments was the drop in yields and consequently the handsome capital gains. With bond yields now at all-time lows and money-market yields barely positive, investors may have to live with the current level of yields for the medium to long term. A more bearish scenario includes a rise in interest rates and negative risk-adjusted returns for government bonds.
That does not bode well for risk parity investors. As shown by Asness, Frazinni and Pedersen, risk parity strategies do poorly when interest rates rise. Their paper shows the performance of a risk parity strategy was almost flat from 1962 to 1986, while a traditional asset allocation portfolio did quite well. That is more than 20 years of underperformance.
RISK PARITY, YES, BUT WITH FEWER GOVERNMENT BONDS
In conclusion, risk parity can suffer from asset overvaluation. And it can suffer for longer than most investors can tolerate. This is particularly the case for government bonds: since there is no strong negative relationship between volatility and government bond returns, the rebalancing to target constant risk is not going to help reduce the weight of government bonds when returns sour. Today, we would feel uncomfortable with a leveraged portfolio where government bonds take up the biggest chunk of the capital invested. We would prefer a portfolio still relying on target risk approaches and rebalancing asset weights to keep risk budgets constant over time, but with a risk allocation to government bonds lower than that typically found in risk parity strategies.[starbox id=raul.leotedecarvalho][starbox id=andrea.mossetto]