Risk parity post-Brexit
Despite the increase in risk in many asset classes from a year ago, risk parity funds have weathered this summer’s volatile markets.Apollon Fragkiskos reports
At a glance
• Risk parity starts from the observation that in a balanced portfolio the risk comes mainly from equities.
• The risk parity approach allocates assets so that the contribution of each asset class to portfolio risk is equal.
• Risk parity funds have weathered this summer’s volatile markets fairly well.
On 24 June 2016, the day after the Brexit vote, six risk parity funds showed significant drawdowns. Three months later, while the equity and credit markets have demonstrated positive performance, the rest of the asset classes that risk parity funds typically invest in (commodities and fixed income) continue to fare less well (figure 1).
However, the diversified nature of the risk parity approach has helped these funds boost their performance since the Brexit referendum, more than reversing that day’s losses and exhibiting positive returns.
An interesting observation is that by decreasing the exposure to an asset during periods of high risk, the risk parity strategy has effectively achieved a higher Sharpe ratio than if it were to increase exposure. Increasing the exposure would be the case for many non-risk parity multi-asset portfolios, which rebalance to policy asset weights.
Risk parity implementation starts from the observation that while a traditional 60/40 equity/bond portfolio appears to be well diversified, equities are more volatile than fixed-income securities. Hence, the risk from equities dominates. In fact, for the 25-year period ending 16 September 2016, a 60/40 US equity/bond portfolio’s returns would have a 99% correlation with equities and almost 100% of its risk attributed to equities. That is not as well-diversified as hoped.
To address this problem, the risk parity approach allocates assets so that the contribution to total portfolio risk of each asset class is equal – that is, assuming bonds are half as volatile as stocks. In a simple risk parity approach and assuming zero correlation between stocks and bonds, the manager would allocate twice as much weight to bonds so that both asset classes have equal volatility. This would increase the diversity of the portfolio, which in turn should improve risk-adjusted returns.
In creating this portfolio, the manager assumes that the return per unit of risk between stocks and bonds is going to be roughly identical. If not, the manager would be better served investing solely in the asset class with the best risk/return characteristics. From a modern portfolio theory standpoint, a risk parity portfolio is mean-variance efficient if the Sharpe ratios across assets are identical and correlations across assets are the same. Proponents of risk parity claim that since, in expectation, Sharpe ratios among asset classes are equal, even if correlations are not, it is difficult to find in advance a portfolio that is more efficient than the risk parity portfolio. In other words, a risk parity portfolio may not be perfect, but finding a better alternative is difficult.
Risk parity portfolios will allocate more weight, or apply leverage, to asset classes with lower risk. If the risk/return profile among assets is expected to be the same, leveraging the risk parity portfolio to a certain risk target is expected to produce the same return, no matter what the underlying assets are. But the risk/return profile between asset classes is the same only in expectation. Not only can it vary considerably depending on the time period, it can also vary depending on the level of risk of each asset class. Since risk parity assigns more weight to low risk assets, one would hope that such assets would have a better risk/return profile.
To shed some light on this point, using daily data we measured the realised one-year return and standard deviation (risk) of returns for asset classes that may appear in a risk parity strategy. We used a rolling window of roughly 250 trading days, moving forward one trading day to create a new one-year observation. This analysis covered every day and for a period extending as far back as 30 years prior to 16 September 2016, resulting in 7,743 one-year periods for the asset class with the longest history, US equity. For each asset, we grouped each one-year period into either a low-risk (risk in the bottom half of each asset’s entire time period) or high-risk (risk in the top half of each asset’s entire period). To compare the risk and return for each asset class, we plotted the one-year Sharpe ratio by the low-risk and high-risk groupings.
Over the entire study period, eight of the asset classes in low-risk time periods experienced greater risk-adjusted returns versus high-risk periods, on average. US equities for example, represented here by the Russell 1000, have a Sharpe ratio of 1.21 in low-risk periods, while they have a Sharpe ratio of 0.58 in high-risk periods. This Sharpe ratio behaviour was consistent across all equity and credit indices we looked at, while commodities had higher Sharpe ratios in high-risk periods and fixed income was rather indifferent.
Sharpe ratios can also be grouped into high and low groups based on total risk. It turns out that for some asset classes like US equity, there is an almost linear decrease in the Sharpe ratio as risk increases.
It is also possible to examine the relationship between Sharpe ratio and standard deviation for US equities.
This shows that equities do not always generate higher returns in low-risk environments. While true when examining the average one-year returns at those periods since 1985, in the post-financial crisis period equities have generated lower returns on low-risk environments. It is the risk-adjusted returns that tend to increase in low-risk environments.
This insight may explain some of the recent gains of risk parity funds. Risk parity allocates higher weights to assets with lower risk. If, as we have seen, an asset’s Sharpe ratio and risk are inversely related, risk parity dictates increasing an asset’s weight in periods of higher (expected) risk-adjusted returns.
Despite the increase in risk in many asset classes from a year ago, risk parity funds have weathered this summer’s somewhat choppy asset markets fairly well. We can hope that the empirical Sharpe ratio behaviour of some asset classes will keep acting as a tailwind for future performance.
Apollon Fragkiskos is the director of research at Markov Processes International