A simplistic view of ‘risk parity’ associated with multi-asset strategies has distorted its potential, argues Edgar Peters, partner and co-director of global macro at First Quadrant.

‘Risk parity’ is a term that has become associated with multi-asset strategies where the risk is naively allocated equally across asset class. Unfortunately, this simplistic view of risk parity has distorted its real potential and caused some in the investment community to force any such multi-asset strategy into its own box. This is unfortunate because risk parity is a technique that should be more properly called ‘risk weighting’ and is just another form of asset allocation.

Risk weighting should take its place among other asset allocation techniques such as ‘capitalisation’ or ‘equal’ weighting. In fact, risk weighting is just another form of optimisation that relaxes one common and binding constraint: no leverage. The focus on the dangers of leverage has sidetracked investors from realising that risk-balanced portfolios are merely another version of ‘diversified growth’, but one that is focused on diversifying both growth and risk to achieve a higher return at lower risk. It also does not mean ‘equal’ risk weighting is necessarily applied, making the ‘parity’ part of the risk parity label misleading.

In fact, looking at the investments inside a typical risk parity fund and any popular diversified growth fund finds there is only one real difference - the duration of the bonds that are in the portfolio. The goal of multi-asset, risk -parity portfolios is the same as a diversified growth portfolio. That is, equity-like returns at reduced risk. Risk parity portfolios do this by not only diversifying the assets that grow when the economy grows but also including a significant allocation to an asset that will reliably grow during economic decline and deflation: long duration sovereign bonds created synthetically in the futures markets. 

Thus, a multi-asset, risk-parity portfolio is expected to give diversified growth in all phases of the business cycle because it contains not only cyclical assets but counter-cyclical assets.

Traditional diversified growth funds rely exclusively on tactical asset allocation (TAA) methods to reduce the exposure to risky assets during such times through their own skill.  Interestingly, risk parity managers also use TAA, but do not exclusively depend on such methods to hedge the portfolio against economic decline or a sudden tail-risk disaster like a terrorist attack or a large earthquake. Sovereign bonds are not only counter-cyclical, they are natural flight-to-quality assets during times of uncertainty regardless of the interest rate. 

During the Japanese earthquake of March 2011, Japanese stocks fell, and Japanese bonds rose even though the bonds yielded slightly more than 1%. But the only way such holdings can truly hedge against equity tail risk is if they have a long enough duration, and such a duration can only be achieved by leveraging sovereign bonds in the futures markets. Risk allocation techniques allow diversified growth portfolios to include assets that grow when the economy declines and also hedge against unexpected tail-risk events when a TAA move will be too late.

So risk parity is an asset allocation technique for truly diversifying risk, not an investment strategy on its own. Putting multi-strategy diversified growth portfolios that use risk-weighting techniques into a separate box puts investors at a disservice. By diversifying risk in addition to diversifying growth, a multi-asset, risk-parity portfolio can hedge against market conditions such as those that have prevailed in 2011 and 2008 while participating in the growth of 2009 and 2010. What is commonly and erroneously called risk parity is just another flavour of diversified growth, but one that diversifies both risk and growth to achieve equity-like returns at lower volatility. Isn’t that what investors need in these uncertain times?

Edgar Peters is a partner and co-director of global macro at First Quadrant