Risk parity: riding out volatility through leverage

3 Jul 2012

In an investment world turned upside down, institutional investors are looking for a strategy that rewards the risk taken in their portfolio. Liability driven investment (LDI) has been seen as the pragmatic route to removing unrewarded risk, but does risk parity investing offer a potential antidote to the wonderful world of volatility we face today?

“Where else might you get the same kind of promise as a hedge fund, but with a fixed fee?”

Ed Peters

Proponents of risk parity claim it is an effective way to reduce risk without sacrificing returns, claiming performance similar to traditional balanced 60/40 equity/bond portfolios, but – and this is the whole point – with far less risk, making it a natural fit for schemes desperate to minimise deficits.

Risk parity – also known as risk premia parity – rejects the traditional portfolio in favour of one that diversifies across asset classes. Instead of allocating along the lines of targeted return and determining how much each portion of the portfolio might deliver, the level of risk is equalised across all asset classes.

So, in risk parity the allocation to each of the asset classes is set so the volatility is the same in each case. Sounds difficult, but the job of a risk parity manager is “not enormously complicated”, says AQR Capital Management principal Mike Mendelson, as it is all about building risk diversification.

“The objective of risk parity is to make risk matter in all the portfolio, but not for any of it to matter too much,” he says. “Conceptually, all you are trying to do is use what is supposed to be diversification to get a higher risk-adjusted return. But you will only get that if you are properly risk adjusted.”

This cannot be achieved in a traditional portfolio, says Mendelson, not because traditional managers have got it wrong, but because traditional allocation is driven by a very strict ‘no leverage’ constraint. To achieve that, investors need a 60/40 – or similar – portfolio which is very concentrated in terms of risk.

Bond function

Many will see risk parity as a multi-asset portfolio, says First Quadrant co-head, global macro Ed Peters, very similar to diversified growth funds (DGFs). However, the difference between a multi-asset portfolio and a DGF is in the function of the bonds in the portfolio, he says.

In DGFs, bonds are used much like in a regular balanced portfolio to reduce volatility, but this also reduces returns because managers tend to use intermediate duration bonds.

“As equities fall in value, sovereign bonds increase, so there is a negative correlation,” says Peters. “There is also a deflation hedge – when an economy is weakening, bonds will have a capital gain.”

But traditional portfolios do not see much increase when equities are on the slide because there is not enough risk, so risk parity managers will increase the duration of the bonds. “This way you get truly diversified portfolio and make money when markets go down as well as up.” Peters claims such a strategy will deliver an equity-like return with 9% risk – equities may be around 17% – and only a 50% correlation to equities rather than the 90% correlation most DGFs display. This is achieved by the use of long-dated (20-year) zero coupon bonds.

There are five key markets targeted by the risk parity managers – US, UK, Germany, Japan and Australia. Occasionally, Canada may be the sixth, but they are selected because they are all highly rated, very liquid government bonds.

Using leverage

However, there is not a global supply of 20-year zero coupons bonds, so risk parity managers will leverage 10-year bonds in the futures market. The managers do this by buying more than the face value of the bonds to back up their position, typically 2:1 or 3:1 the face value of the bonds. This is where some people tune out – when they hear the word leverage – but this “economic leverage” is quite different from the leverage used within the normal securitisation model, with its accompanying counterparty risks we are now so familiar with, says Peters (see on page 3).

Mendelson agrees, pointing out that many investors will already be comfortable with this form of leverage. “Institutional investors are already using leverage in hedge funds, real estate and so on. It is about the judicious use of leverage, not what happened to make the world the way it is today.”

Universities Superannuation Scheme co-head of multi-asset allocation Arne Hassel believes risk parity makes sense as a long-term approach to strategic allocation. “It puts the emphasis on diversification without having strong views on the long-term returns of different asset classes. Over the past few years it has been a great strategy because of the large allocation to the rallying bond markets.”

This success is also the biggest hurdle for the strategy now, says Hassel, as many funds may feel they are late to the party and bonds are too expensive, but bonds do not have to continue to rally to be a good investment.

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