By Wai Lee
Much has been made of how risk-parity strategies have recently struggled given a backdrop of tumbling prices across asset classes. Many in the financial media have focused on the “failure” of risk parity to produce positive returns despite the (disputable) contention that such strategies have been engineered to generate returns regardless of market environment.
The basic idea behind a risk parity portfolio is to invest such that equal risk contributions come from the portfolio’s various components. The rationale is that a long-only portfolio that invests based on risk expectations of asset classes – rather than forward-looking return forecasts that can often be prone to errors – will be more robust over the long run and better positioned to withstand a variety of market environments.
There are typically three building blocks that go into constructing a portfolio, namely the investor’s views on: expected return of assets, volatility of assets and correlation among assets. Such views change over time. A portfolio with static, predetermined weights to stocks and bonds, such as a standard 60/40 mix, does not respond to changes in these views. A risk parity portfolio, on the other hand, takes a proactive stance in using these forecasts –in particular volatility and correlation assessments – to construct portfolios that can potentially be more robust.
Using correlation estimates or forecasts, weights in a risk parity strategy can be actively adjusted up or down in a way that we believe should more effectively manage risk over time. In a static 60/40 portfolio, this correlation is ignored entirely, with stocks and bonds often working against each other when maintained in static proportions.
June was an unusual month, in that most stock and bond markets declined, amid what was arguably a market overreaction to potential tapering by the Federal Reserve, while real assets such as commodities and TIPS tumbled given receding inflationary expectations. Still, while atypical, the situation was not unprecedented. So it has been interesting to hear of surprise in some quarters that risk parity – by definition a long-only strategy – would suffer weakness when all three major asset classes in which it invests have experienced losses. Moreover, these critics have noted what they consider poor performance of risk parity compared to 60/40 portfolios in June, often citing leveraged fixed income positions as the reason.
In our opinion, the focus of such a comparison is misplaced. Rather, the more relevant analysis is how accurately investors forecasted the sudden jump in volatility and, more importantly, whether they predicted correlations between stocks and government bonds suddenly turning positive after being negative for years.
In a nutshell, we believe the 60/40 portfolio leaves risk as fate and, therefore, the investor either does not make an attempt to forecast or simply ignores the forecasts. Meanwhile, the risk parity investor takes on risk by choice – albeit suffering more this past June as forecasts of volatilities and correlations were generally proven wrong.
Risk parity is not a panacea. We believe that a risk-based portfolio serves as a useful means to set strategic exposures, where we are defining “strategic” as the core or starting point for a portfolio, distinct from tactical investments that may reflect shorter term or opportunistic views (a distinction that is important for investors to distil when assessing various asset allocation strategies).
Recent market activity has not suddenly uncovered shortcomings in the risk parity approach; on the contrary, it’s well known that this is a long-only strategy built upon estimates of relationships between assets, including correlation and risk. Rather, such a period is a reminder that risk management is not without challenges. Risk is multi-dimensional, where volatility, correlation and even tail risks all play a role. More importantly, these characteristics can and will change over time – sometimes faster than expected.
For investors, we believe the key takeaway is that any approach to asset allocation needs to be flexible and dynamic in order to effectively handle market realities.
Wai Lee is chief investment officer of Neuberger Berman’s Quantitative Investment Group
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