7 Things Advisors Need to Know About Risk Parity
Over the past three years, advisors have witnessed the growing popularity of a global allocation and risk management strategy known as "risk parity."
One of the principal reasons for this growing interest, according to Salient Partners CIO Lee Partridge, relates to the negative experiences many investors have had for more than 12 years with more traditional asset allocation models and additional frustrations with certain alternative investment strategies that often did little to ameliorate those experiences.
The basic concepts underpinning risk parity may generally be described as (1) an effort to distribute risk equally across key elements of a portfolio that are not only lowly correlated with one another but also linked in different ways to certain economic drivers such as growth, inflation or sentiment, and (2) the targeting of a consistent level of portfolio volatility regardless of changing market conditions.
Here are seven facts that advisors and their clients need to know about risk parity.
Source: Lee Partridge, CIO, Salient Partners
One of the key tenets of modern portfolio theory is the notion that if one invests in two or more assets that are less than perfectly correlated with one another, the return of the portfolio is a dollar weighted average of the returns on the two assets; the risk, however, is something less than the dollar weighted average of the two risks, which is a function of correlation.
An equally weighted portfolio of the two assets described above would result in a return figure that is precisely halfway between the return on Asset A and the return on Asset B. By contrast, the volatility only increases by 0.71% (or 11.83% of the distance between the lower volatility Asset B and the higher volatility Asset A). Greater increases of return for lower increases in risk-AKA, the free lunch.
There is a significant difference between the dollars allocated to various assets or strategies within a portfolio and the amount of risk allocated to those same assets or strategies.
Many investors believe they are adequately diversified by holding traditional asset allocation models that allocate 60% to stocks and 40% to bonds. The reality is that their portfolio returns are often being dominated by the stock component of that portfolio.
While only 60% of the dollars are allocated to stocks, over 95% of the portfolio's volatility is typically being determined by the stock allocation while a meager 5% is determined by the bond allocation. In essence, they are running highly concentrated portfolios that are typically betting on positive growth, benign inflation and positive sentiment to promote stocks as the dominant asset class.
Many investors employ scores of managers through various mutual funds, ETFs and even more complicated structures to purchase literally thousands of securities but lack fundamental diversification across their portfolio. The reason is that all of those managers, despite the large number of securities they oversee, are all typically driven by one overwhelming factor: the stock market.
Investors who want to hedge against changing levels of growth, inflation or even investor sentiment could potentially achieve better results by lowering their allocation to equities-even if they only employed one concentrated manager-but increasing their allocations to commodities, interest rate sensitive bonds and certain other diversifying strategies. The response of different asset classes to changing economic conditions is generally higher than the response across individual holdings within an asset class.
One of the key issues with static allocation strategies is that they often lack a response to changing levels of market volatility. Risk parity strategies typically target portfolio volatility levels and then increase or decrease exposures to various asset classes with the goal of maintaining the same level of volatility during all market regimes.
By contrast, the volatility levels in static allocation portfolios increase when market volatility levels or correlations increase and decrease when market volatility levels or correlations decrease.
The main issue with volatility is not the fear factor that causes investors to question whether they will be able to achieve their financial goals as they experience the roller coaster ride of the market, but rather, the impact that volatility has on returns. Consider two investors who have held the following two portfolios for five years:
You might note that Investor B's annual portfolio returns are simply half those of Investor A. That said, some interesting things come from this analysis. The arithmetic return or simple average of Investor A's annual portfolio is 6% but Investor B's is only 3%. Nonetheless, Investor A had a total return of -6.40% while Investor B had a total return of +6.73%. This result offers a depiction of the damaging effect that volatility can have on a portfolio.
Rather than focusing on the dollars allocated to various investments, most risk parity investors concern themselves with the amount of portfolio risk that is generated from each component of the portfolio and seeks to equal the risk contribution of each component in practical ways. This typically helps stabilize results as economic conditions change.
Risk parity strategies have historically resulted in lower risk at the same level of return as compared to traditional allocation strategies. They have also led to considerably lower peak-to-trough drawdowns during periods of crisis like 2008-2009 and 2000-2002.
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Risk parity has become a popular allocation and risk management strategy in recent years. Do you know enough about it to provide guidance to your clients?