Interview: Edward Qian
Christopher O’Dea speaks to Edward Qian, the man who coined the term risk parity and who says it should be adopted at plan level
The acceptance of innovative ideas in the sciences is said to follow a clear, if tortuous, path. The progression runs from initial declarations that the new view is rubbish, to a period of curious inquiry into something that’s interesting but wrong, to the concession that the new idea may, indeed, be relevant in certain cases – but which would, naturally, occur only rarely – to a laudatory chorus of ‘I told you so’ from the newly converted.
Edward Qian says risk parity investing today stands on the threshold of that recognition. Qian coined the term risk parity for a method of allocating assets based on the risk that each asset brought to a portfolio – a conceptual model that challenged the orthodoxy of allocating capital based on market capitalisation and projected returns of asset classes.
Qian, an early innovator and experienced practitioner of risk parity investing, is chief investment officer and head of multi-asset research at PanAgora Asset Management in Boston. He wants to see the approach surmount the final hurdles to widespread acceptance, a desire that motivated him to pen a new book, Risk Parity Fundamentals. In it, he provides a concise, high-impact presentation of where risk parity stands after its first decade, how the strategy has performed, and where the practice of risk-party investing is headed.
A mathematician by training, Qian distils the complex maths essential to risk parity into crisp prose and examples from a decade of being tested, adopted, questioned and, so far this year, validated anew. Ronald Hua, a managing director at Goldman Sachs Asset Management, says the new book is a “must-read”, providing investors with a “buyer’s guide” to the techniques of an investment approach that has received ample attention but rather less structure.
Qian spoke with IPE from his office at PanAgora. In wide-ranging comments on his new book, he discussed how risk parity is being applied today, as well as the need to recognise that some managers claiming to be engaged in risk parity are actually delivering performance based on other factors. The way forward for risk parity, he suggests, is to move from thinking of it as just another strategy to which institutional investors might allocate some capital, to applying the conceptual framework and analytical approach of risk parity across the entire portfolio.
“I hope this book can shed some light on what risk parity is about,” says Qian. Some initially misunderstood risk parity as a “very simple” approach that can be implemented after some straightforward basic training, he says. But rather than providing managers with a tool kit, he believes that risk parity, in fact, provides a different perspective on investing and portfolio construction. “Risk parity is actually just a quantitative concept. When you try to use it in investing you need to combine it with a lot of fundamental insight, such as what risk premiums should be in the portfolio, where you can apply risk parity, and how you should manage a risk parity portfolio.”
In effect, Qian’s book is an appeal to the institutional investment community to make risk parity a way of life. “We advocate a ‘risk parity-everywhere’ strategy,” Qian says. “We do risk parity top-down and bottom-up. That’s the ultimate application of risk parity to investment strategy. We have been managing portfolios like this for the past eight years.”
The first step, Qian suggests, is how you understand the concept and where risk parity is in the portfolio. “A lot of people have bought into the concept, then allocated some small portion, say 5-10% of assets. That’s not a large enough allocation to make the overall portfolio robust to economic shocks.” Shock protection is the heart of the matter, Qian explains. “The essence of risk parity is diversification. If you diversify 5-10% of your portfolio, that’s not a sufficient degree.”
It may take some time before institutions adopt risk parity across entire portfolios. But now that the approach has several years of data behind it, some people are coming around to use risk parity in commodities or equities, Qian notes. “Cap-weighted indices became viewed as dumb beta, and we view risk parity as smart beta based on diversification that can deliver better risk-adjusted returns,” he says.
As with many aspects of investing, the devil is in the details. “There’s a lot of difference in how people interpret risk parity and how they implement risk parity,” Qian says. Some use cap-weighted indices to implement it, which means they may have too much equity risk in their portfolios. Likewise, they may hold a lot of equity-like risk if they put a lot of credit in the portfolio for income purposes. The end result is that, in some cases, investors have something more like a 60/40 portfolio than risk parity.
Over the past few years, Qian observes, there has been considerable performance differentiation between various risk parity providers. This led to what Qian calls the biggest surprise he faced in the course of working on his latest book, which is detailed in chapter seven. Here, Qian compares the performance of several leading risk parity strategies – their identities are not revealed – to determine what each manager was delivering, and how. In three of seven cases, managers were not delivering returns derived from the balance between inflation, interest-rate and equity premia that is the hallmark of risk parity but, instead, from concentrated positions in assets that delivered equity risk or rate risk.
“A lot of people have bought into the concept, then allocated some small portion, say 5-10% of assets. That’s not a large enough allocation to make the overall portfolio robust to economic shocks… The essence of risk parity is diversification. If you diversify in 5-10% of your portfolio, that’s not a sufficient degree”
While it is essential for institutions to understand how their capital is being managed, Qian says insufficient fundamental research is being undertaken to understand the actual sources of performance by managers claiming to be applying risk parity. “This is the kind of work a consultant should be doing, applying style analysis like what’s used with equity mutual funds,” says Qian, who has conducted his own style assessment of seven different managers, modifying style regression models to account for multiple asset classes and leverage.
In discussing the technical challenges that arise when investors and consultants determine how to benchmark risk parity, Qian says “people miss the good old days”. But, as every investor learns at some point in their career, the good old days aren’t coming back. What they need is a way to organise new information and adapt to events that they can’t possibly predict as those events arise. Risk parity, Qian contends, is just that, a sort of Leatherman all-in-one tool for whatever the markets throw at a portfolio – tough, durable and well-designed.
Still, institutions need to track their results against peers and other investments, and Qian admits that identifying the appropriate benchmark for risk parity remains “a thorny issue”. Many like to compare asset allocation portfolios against a 60/40 of a policy portfolio, but given that risk parity portfolios are constructed so differently, “they don’t match each other very well” for purposes of performance measurement, Qian says. Risk parity could also be viewed against a cash-plus portfolio, but while that benchmark would be suitable for the three to five-year timeframe, “most people can’t wait that long” to evaluate a portfolio.
A solution for investors needing an index, Qian suggests, is a simple benchmark comprised of 25% commodities, 33-35% equities, and 142% for global bonds to cover the inflation, equity and interest rate risk premia, weighted according to volatility estimates for each asset class. The portfolio would have 200% leverage. “Subtract cash and that is a pretty good benchmark. We are not a benchmark shop, but we’d advocate using that,” Qian says.
All in all, risk parity is about improving investment returns. “Our backtests tell us to stay away from cap weighting and use the risk parity approach to construct portfolios, because they usually deliver better returns with slightly lower risk,” says Qian. Still, critics of the strategy persist. One of the more vocal, noted in the book, is GMO which, as recently as last summer, said risk parity investors, since they buy when volatility falls and sell when it rises, could turn into sellers at unsettled times.
For his part, Qian notes in his book that the return-based allocation used by GMO builds portfolios by relying on forecasts of returns for individual assets that Qian says are “quite uncertain”. Risk parity, in contrast, uses a diversification concept to build portfolios intended to weather inevitable market shocks, without trying to predict which factors will cause any given downdraft. The next few years are likely to present investors with rising volatility, extraordinary uncertainty about economic growth, monetary and fiscal policy and ongoing shifts in global commodity markets.
In rebutting the GMO critique, Qian states that over the four-year period from December 2009 to December 2013, a model risk parity portfolio with 50% of capital allocated to stocks, and 150% in bonds, with 200% leverage posted a 12.14% annualised return, compared with 8.23% for a 60/40 portfolio. That period covers the 2103 taper tantrum, in which risk parity performed poorly against the 60/40 portfolio when bond markets underwent a substantial repricing. That episode “was an exception rather than a rule”, Qian writes.
If risk parity helps portfolios weather those storms, there will be many investors claiming “I told you so” when the clouds clear. That will suit Qian. Some US endowments and foundations now allocate one-third to one-half of their assets to risk parity, and some “bold” pension plans allocate 15% or more to the strategy, he says.
Denmark’s ATP is one of the few pension funds that has adopted a risk parity approach across its investment portfolio (see article in this section). “Hoping for adoption for the total portfolio may be too optimistic,” Qian says. “But that’s my view: risk parity should be adopted at the total plan level.”