Risk Parity: The Second Generation

Coverage of the 2013 Global Investment Conference.

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generation feetRisk-parity strategies have garnered great interest recently, not to mention significant capital — roughly US$100 billion since the end of 2012.1As risk-parity strategies have become more widely used, they have also evolved to meet the needs of plan sponsors. Specifically, a new generation of strategies has moved away from “pure parity” and combined broad diversification with enhanced risk-management practices.

Defining risk parity

While risk-parity strategies can vary widely in their philosophy and implementation, generally, they share three core ideas. First, asset allocation should be based on risk, not dollars. A so-called balanced portfolio with 60% in global stocks and 40% in global bonds is actually not balanced in risk terms. More than 90% of the risk comes from the equity allocation — a result of equities being much more volatile than bonds. Risk-parity managers actively seek to achieve a more balanced risk profile.

Second, risk-parity strategies should be diversified across asset classes and regimes. They go beyond stocks and bonds, typically including exposure to inflation-linked securities, commodities and other asset classes. These assets are expected to do well in a range of economic environments.

Third, risk-parity strategies make a trade-off between concentration risk and leverage risk that can add value. To create better balance, risk-parity managers have more exposure to less volatile assets and less exposure to more volatile assets. The resulting portfolio has a high risk-adjusted return, but its volatility (and, therefore, its total return) is modest. Risk-parity managers use liquid futures to lever the portfolio and seek a higher level of risk and return. Often, the volatility is calibrated to about 10%, equivalent to the long-term volatility of a 60% equity/40% bond portfolio.

A new generation

The first generation of risk-parity strategies focused on diversification across broad asset classes and generally put a premium on true parity in their asset-class exposure. Today, a second generation of strategies puts a premium on risk management and seeks balance across asset classes rather than strict parity. These attributes make them a potentially better model for institutional investors.

For example, while first-generation risk-parity strategies often used market-capitalization indexes for stocks, bonds and commodities, second-generation strategies focus on diversification within asset classes. They use “smart beta” portfolios of individual stocks, bonds, commodities and currencies that are better balanced across sectors and geographies — often with a tilt to quality or low-volatility characteristics — and, as a result, are more resilient in periods of boom and bust.

Second-generation strategies may also manage to a constant volatility target for each asset class, which means they can dynamically adjust the portfolio’s exposure to different asset classes based on near-term risk assessments. So, while a static portfolio of equities has seen its short-term volatility range from less than 10% to more than 50% over the last decade, a simple model designed to predict and react to changing volatility can result in much more consistent portfolio volatility and fewer large drawdowns.

Improvements to risk-parity strategies also include more opportunistic portfolio protection. While the cost of maintaining a long-term hedge against market declines is prohibitive, there are times when the price of this insurance is cheap. Second-generation risk-parity managers seek to include opportunistic protection against events like falling stock prices or rising interest rates. These newer strategies may also incorporate tactical asset allocation, seeking to add value by overweighting more attractive assets and underweighting those at greater risk of loss.

Second-generation risk-parity strategies may also enhance diversification with exposure to “alternative” betas — those not associated with a particular market or asset class, such as carry, momentum, value and size.

Ultimately, risk-parity strategies seek to outperform more traditional, equity-centric approaches to asset allocation. Many institutional investors incorporate risk parity by making a 5% to 10% portfolio allocation, and some seek to embrace these concepts more broadly by diversifying away from equities and into other asset classes at the overall portfolio level. The ideas underlying risk parity — especially second-generation techniques to better manage risk ― can be adopted by a wide range of investors, whether or not they make specific risk-parity strategies part of their portfolio.

1Sources: eVestment, Wellington Management

By Adam Berger, CFA, is Asset allocation strategist, Wellington Management

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