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Risk and Portfolio Construction: Risk parity preferences

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  • Risk parity preferences

The ‘equal risk’ or ‘risk parity’ approach to asset allocation is garnering a great deal of attention from institutional investors.  The approach argues that capital should be allocated in such a way that the volatility of each asset class multiplied by its weight in the portfolio is the same.  So an asset class with low-return volatility would need a higher weight than one with high-return volatility.

For example, suppose that an investor was considering investing in just two asset classes, one with volatility of 10% and the other with volatility of 30%. A risk parity approach to the weighting of these asset classes would require that the investor invested 75% in the low volatility asset class and 25% in the high volatility asset class.

At Cass Business School’s Centre for Asset Management Research (CAMR) we have been investigating the impact that a risk parity approach to investing can have on a multi-asset class portfolio (a full version of this research can be found at the Social Science Research Network website, www.ssrn.com). We collected return data on the sub-components of five broad asset classes: developed and emerging market equities, developed economy bonds; commodities; and commercial property. Altogether we used data on 95 individual asset classes.

We then calculated the performance statistics for a simple buy-and-hold strategy for the five main asset classes, where we allocated 20% of the portfolio to each of the five asset classes (following the principles of ‘1/N investing’, which advocates allocating equal amounts of capital to each asset class of interest). If there are 10 (N) asset classes then the approach simply requires that each asset class has a weight of 10%.

Next we formed a portfolio based on these five broad asset classes, where the weights were set at the beginning of each year so that each broad asset class had the same weighted volatility as every other asset class, based on the volatility of that asset class over the previous year.

The first two bars of figure 1 show the return achieved from both approaches. They are almost identical. The 1/N approach achieved a return of 6.71% per annum, while the risk parity approach achieved a return of 6.78%. Not very encouraging really.

Risk parity preferences

However, we also applied the same approach within each asset class. These results, also shown in figure 1, are more encouraging. In most cases a risk parity approach seems to have enhanced returns, in some cases quite considerably. For example, a 1/N approach to an investment in a wide range of emerging market equities would have produced an average annual return of 5.48%, while a risk parity approach produced a much more impressive return of 9.58%. This result suggests that investors were not being rewarded for exposure to very risky emerging equity markets and that, by comparison, overweighting the less volatile emerging equity markets would have been a more profitable strategy.

Now let’s now consider the risk in these strategies. Figure 2 shows the maximum drawdown statistics for each of the strategies and asset classes shown in figure 1. A portfolio’s maximum drawdown is the maximum peak to trough decline in its value over a particular time period. This statistic should be of crucial interest to any investor that might need to access their funds in a hurry, or if they are approaching retirement, or if they have retired and are in income drawdown.

The interesting feature of figure 2 is that when applied across broad asset classes, risk parity can reduce the maximum drawdown compared to a 1/N strategy: from 47% to just 20%. However, within broad asset classes the maximum drawdown is almost the same for both approaches. And in the case of developed economy bonds, it is considerably worse.

Our results indicate that a risk parity approach to asset allocation may not enhance return when applied to a range of broad asset classes, but that it might reduce drawdowns – a key concern for investors. Conversely, our results with regard to, for example, the choice of weights for a global equity portfolio suggest that a risk parity approach to the weights might enhance the return over time, but may still leave the portfolio vulnerable to a large drawdown. In other words it may enhance the average return, but it does not eliminate the downside risk that investors fear most.

Overall, risk parity does appear to offer something to investors, although it may not be the investment panacea that some of its proponents claim.

Andrew Clare is professor of asset management at Cass Business School

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