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Surviving Market Cycles: The Risk-Parity Approach

The new "risk-parity" approach to portfolio construction is based on the premise that investors aren't truly diversified

Samuel Lee 9 August, 2012 | 10:06AM

Five years ago, who would have predicted that the rich world would reprise the Great Depression?

And yet here we are. The surprising frequency of the "unthinkable" happening suggests we are overly confident in our ability to see the future. The "risk-parity" approach to portfolio construction is a powerful way to combat this mistake. Pioneered by Bridgewater Associates, modern risk-parity portfolios adhere to a simple principle: balance exposures across all the major economic scenarios by volatility. The hope is that such a portfolio will perform well in all economic climates--and indeed risk-parity strategies have.

The strategy is gaining influential adherents, mainly among institutions, but hasn't caught on with individuals. Will this strategy work in the future? Could an individual investor apply it? I think the answer is, tentatively, yes to both questions. To understand why risk-parity works, we have to revisit a common fundamental misconception of portfolio construction.

The typical investor thinks of assets as being like indivisible elements, with distinct characteristics. In contrast, the risk-parity approach begins with the observation that asset classes can be described in much the same way atoms can be described as combinations of electrons, protons, and neutrons. The fundamental particles in the risk-parity view of the world are inflation and economic growth. This isn't a modern insight, but one that's been around academia for decades. The risk-parity application is relatively new, however.

Standard portfolio construction advice does not lead to risk-balanced portfolios. The typical 60% stock/40% bond portfolio's volatility is 90% determined by equities, which are reliant on declining inflation and economic growth. What happens when inflation ticks up or growth slows? Standard portfolios fail.

The Four Economic Configurations
Economies have four main configurations (shown in the chart below), characterised by combinations of rising/falling inflation and rising/falling economic growth. Changes in inflation and economic growth can explain the gross behaviour of almost any asset class.

Naturally, in each phase of the business cycle, different assets are king. Stocks do best when the economy is growing and inflation is falling, coinciding with the recovery phase after a recession; bonds do best when the economy is tanking and inflation is falling, coinciding with the downward leg of a conventional recession. These are sensible relationships--stocks rise in anticipation of increased earnings growth, and bonds rise when inflation or interest rates fall. For the most part, it doesn't really matter what kind of stocks or bonds you own--whether they're growth/value or corporate/Treasuries--each asset class will largely obey its relationship to economic growth and inflation.

Unsurprisingly, the equity-risk-dominated 60/40 portfolio does best during disinflationary booms. Assuming the historical distribution of economic scenarios is a decent guide to the future, the 60/40 portfolio is heavily geared to do well about half of the time. This is tolerable if the bad months are randomly interspersed with good months. However, history suggests economic scenarios are clumpy, sometimes lasting decades, lulling investors into only preparing for the risks that have showed up in recent memory.

Investors failing to hedge their bets against all four economic scenarios are implicitly betting on their prescience and exposing themselves to big tail risks. This seems foolhardy, given that in the past 40 years we've had inflationary recessions (1970s), a deflationary recession (2008–09), and disinflationary booms (1980s and 1990s). The practical outcome of risk-parity thinking is to add more inflation hedges to the conventional 60/40 portfolio, reducing equities' volatility contribution.

The Original Risk-Parity Strategy
Harry Browne's Permanent Portfolio is probably the most well-known risk-parity-like strategy. Browne kept it dead simple: 25% allocations each to gold, long Treasuries, equities, and cash, roughly balancing one's risk exposures across all four economic configurations. While it is crude compared to newer volatility-targeted risk-parity strategies, the Permanent Portfolio has stood the test of time. Over the period 1973–2012, its Sharpe ratio, defined as return above cash divided by its standard deviation, was a respectable 0.48, better than the 60/40 portfolio's 0.40. The Sharpe ratio understates its advantage, because the strategy had smaller drawdowns, less fat-tail risk, and the ability to hold up well when you needed it to.

However, investors expecting the Permanent Portfolio and its variations to repeat last decades' performance are in for disappointment, I fear. Browne's strategy is reliant on now richly valued hedge assets, gold and Treasuries. Investors should expect only low-single-digit real returns from today's valuations.

Beyond the Permanent Portfolio
Several risk-parity funds attempt to earn higher returns by applying leverage to balance the volatility contributions of a variety of asset classes, including commodities, corporate bonds, and currencies. The theory and expectation is that leverage allows the funds to be more efficiently diversified without sacrificing returns; an unleveraged portfolio will have high risk-adjusted returns but low absolute returns--the problem faced by the Permanent Portfolio. Why should this theory hold?

In an ideal world, it should not. Even in a less-than-ideal world, investors would observe the strategy's excess returns and arbitrage it away. Is the risk-parity cat out of the bag? Maybe not. If your reaction upon hearing the word "leverage" is alarm, you are not alone. And this widespread revulsion may keep risk-parity profitable. Leverage is anathema to many investors, meaning a sizable class of investors resort to riskier assets to achieve their expected-return targets. We are observing such a shift today: investors are shifting from bonds to dividend stocks to boost their yields, even though classical finance theory says that they should be borrowing money instead. The result of leverage aversion is that low-volatility asset classes offer higher risk-adjusted returns, which can be exploited by investors willing to use leverage--that is, risk-parity investors.

Two risk-parity hedge funds offered in the UK are the AC Risk Parity 7 Fund GBP B and the AC Risk Parity 12 Fund GBP B. These funds are offered by Aquila Capital, a Hamburg-based alternative investment company. The funds currently have more than EUR 1.2 billion in assets under management and are available to institutional and individual investors. According to Aquila, “the funds ... apply a unique investment approach that allocate risk across different asset classes.”

Even if you don't fully trust these newfangled risk-parity strategies, it's still worthwhile to stress-test your portfolio to see how sensitive it is to all four economic scenarios.

The original version of this article appeared in the June 2012 issue of Morningstar ETFInvestor.

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About Author

Samuel Lee  Samuel Lee is an ETF Analyst with Morningstar.