Sanjoy Ghosh of PanAgora Asset Management explains how the risk parity methodology can be used to create a diversified and risk-balanced portfolio, without sacrificing returns
A well-diversified portfolio is important for proper wealth creation. A portfolio with many holdings within a single asset class, or with holdings that span multiple asset classes, is often thought to be well diversified. However, this sort of diversification is misleading. In reality, these portfolios may actually suffer from risk concentration. Often the investor may find himself exposed to risks of which he was unaware.
For example, common stock indices such as the S&P 500, published by Standard & Poor's, have sector and style risk concentration. Similarly, the S&P Goldman Sachs commodity index has risk concentration in a particular sector. This form of risk concentration reveals that widely used market indices are less diversified than previously thought. We illustrate the risk concentrations in several commonly used indices in figure 1.
To reap the true benefits of diversification, there is a need for a suite of offerings that equally balances risks across its constituents, resulting in higher risk-adjusted returns. This assertion was made, and proven, in an important paper published in The Journal of Investment Management in 2006 by Edward Qian, ‘On the financial interpretation of risk contribution: risk budgets do add up', which noted a linkage between risk distribution and financial outcomes. Risk parity - the term was coined by Qian - is a methodology that is used to balance risk among its constituents in an optimal fashion, so as to avoid risk concentration - be it in asset class, or in a risk cluster within the asset class. Thus, the risk parity methodology offers true diversification, which is crucial in any risk or wealth management process.
Risk parity methodology - horizontal and vertical
The methodology behind risk parity can be applied in a multi-asset-class portfolio that has exposure to equities, bonds, commodities, alternative investments and inflation-hedging instruments. In this form of ‘horizontal risk parity', we apply risk balance across several asset classes, thus ensuring there is no risk concentration within any given asset, such as equities. There are several academic and practitioner papers that explain the details as to why this methodology results in better diversification and protects the portfolio from severe losses when equity markets perform poorly. These papers argue that by levering up less volatile asset classes, such as bonds, risk parity results in more ‘balanced' portfolios, through a reduction in equity risk concentration.
While the 60/40 stock/bond portfolio is often thought of as ‘balanced', it has a significant amount of risk concentrated in equities. It fails to offer true diversification because 95% of the risk profile is from equity-like risky assets. This holds true for different measures of risk - be it standard deviation, or value at risk. Recent market events have provided further validation of the downside risk in these portfolios. Clearly there is a need for a portfolio that is ‘truly' diversified.
Even though typical pension fund portfolios contain several other asset classes - like real estate, hedge funds, private equity, commodities- the portfolios still have risk concentrations both across and within asset classes. Figure 2 shows data from the latest Asset Allocation Survey from the Council of Institutional Investors on the average asset mix of corporate, public and union pension funds.
However, there is a large disconnect between risk allocation and capital allocation, a distinction that is critical when creating a truly diversified portfolio. We see an illustration of this in figure 3, with the pie chart on the left representing capital allocation of a typical fund, where about 60% is invested in risky assets. However, this results in over 95% of the risk being allocated to risky assets. The fact that risk allocation can differ substantially from capital allocation is illustrated below.
‘Horizontal' risk parity balances risk between different kinds of risk premia - equity risk premia, real interest rate risk premia, and inflation risk premia. This form of risk allocation leads to better risk premium capture - this is the essence of risk parity methodology.
The risk parity methodology can also be applied in order to avoid risk concentration within a single asset class. In this form of ‘vertical risk parity', risk is balanced along dimensions that are particular to that asset class. For example, applying risk parity within equities avoids risk concentration in sectors, countries, as well as individual stocks. Similarly, applying the risk parity methodology in bonds prevents risk concentration within certain segments of the credit or duration spectrums. Lastly, the application of the risk parity methodology in the commodity space reduces concentration in pro-cyclical sectors, such as energy.
Better ‘premium capture' through risk parity
Investors seek compensation for taking on risk - and so, every asset class that is risky must offer some sort of risk premium. However, capturing this premium is both an art and a science. We assert that the risk parity framework is a methodology that better captures associated risk premium than some commonly used alternatives.
Risk concentration is often overlooked. We illustrate the benefits of risk parity within an asset class using equities as an example. Within equities itself, there can be too much risk concentration in certain groups, or clusters. These clusters are sectors, industries, countries, regions, or even risk styles like value, momentum, beta and market capitalisation, among others.
Consider the commonly used MSCI World index. Even though this index has more than 1,500 names from over 20 countries, it is not truly diversified. The benchmark has sector and country concentration risk, as well as risk concentration in certain styles, such as size and momentum. Application of risk parity within equities can be used to balance several different types of risk concentration: factor risk, country risk, sector risk, as well as stock specific risk.
Due to its weighting scheme, the capitalisation-weighted portfolio has risk concentration in stocks that have had the greatest price appreciation. This leaves the portfolio very exposed to ‘bubbles'. During bubble years, the index tends to load up most heavily on the frothiest stocks. When the bubble bursts, the investor suffers badly. This popular index has risk concentration along the size spectrum. Most of the risk is concentrated in the mega-cap names, and consequently the smaller names have very little impact on actual performance. Thus, performance is being driven by few factors - clearly illustrating that there is risk concentration. The S&P 500 also suffers from risk concentration. Even though it is hugely popular and widely used since its first publication in the 1920s, it does not represent a truly diversified equity portfolio. While the perceived benefits of capitalisation weighting - minimal rebalancing requirement, high liquidity and supposed easy access to a diversified portfolio - are well known, the inherent perils of risk concentration are often ignored.
The risk parity construct not only results in a more stable return stream (lower volatility), but also results in higher risk-adjusted returns. In practice, the risk parity methodology tends to overweight lower volatility groups that have lower inter-group correlation. Consequently, the portfolio does well in risk-averse environments. It could be argued that these environments are exactly the times when downside protection is most valuable. Risk parity is based on risk allocation, which is much more stable than capital allocation (since capitalisation weighting is driven by notoriously volatile prices).
Back-tests were run using the risk parity equity construct in multiple universes to test for robustness. The back-tests were run from December 1994 to September 2010. Universes tested include regional, as well as global, stocks. Results were compared against commonly used equity indices, namely MSCI World (Global), S&P 500 (US), MSCI Japan, MSCI Europe and MSCI Emerging Markets. The gains from using risk parity were robust across all indices. Interestingly, not only did the risk parity construct lead to higher risk-adjusted returns, it actually resulted in higher raw returns.
In the risk parity construct, weightings on different groups such as sector and country are far more stable, and less exposed to bubble formation and bubble bursting, than a cap-weighted portfolio. Stability of portfolio characteristics is critical in diversifying away ‘timing risk'. Investors who bought into the S&P 500 around 1999 when the dot-com bubble peaked would have paid a big premium to gain equity exposure - something that could have been avoided in the risk parity construct. Cap-weighted portfolios would have had too much risk allocated to the technology sector, which had become increasingly expensive, leaving the investor with high exposure to the internet bubble. Alternatively, the capital and risk allocation to the technology sector in the risk parity portfolio was far more stable before, during and after the bubble.
Risk balance results in higher risk-adjusted returns
One reason why the balanced risk allocation approach yields higher risk-adjusted returns, is that it diversifies, to a certain extent, the risk of incorrectly timing the investments. When the components of the portfolio have similar risk-adjusted returns, then allocating risk equally across these components represents not only a balanced allocation of risk, but also an optimal one. Risk parity can be applied across asset classes, as well as within. This results in better diversification. Empirical results affirm these efficiency gains and are very robust across and within different asset classes. Thus risk parity methodology is a valuable construct that can be used to create a truly diversified and risk-balanced portfolio, without sacrificing returns.
Sanjoy Ghosh is a director at PanAgora Asset Management.