classes needs to be answered. In the context of Risk Parity, there is
an additional question of whether equity allocations can, or should,
be “sacrificed” from their historical 60% level if the expected
equity risk premium is above long-term averages. Institutions face
significant funding shortfalls as a result of the recent bear market.
In this environment, can a portfolio such as Risk Parity, which has
significant fixed-income exposure, continue to provide the required
rate of return for most plan sponsors?
To address these questions, we analyze expected returns based
on scenarios of risk and return assumptions. Table 3 lists a base case
scenario, in which both Sharpe ratios are 0.30, with volatility of 15%
and 5% for stocks and bonds, respectively. These assumptions imply
expected excess returns of 4.5% for stocks and 1.5% for bonds. We
also assume a correlation of 0.1 between stocks and bonds. It then
follows that 60/40 would have an expected Sharpe ratio of 0.35 while
Risk Parity’s Sharpe ratio is 0.40.
Risk Parity (C)
If we alter the base case scenario by changing the Sharpe ratios
of stocks and bonds, the resulting 60/40 and Risk Parity portfolios
would have different expected returns and different Sharpe ratios,
while the expected risk remains the same. In the first case, we
change the Sharpe ratio of stocks from 0.0 to 0.6, while keeping
that of bonds at 0.3. The Sharpe ratios of 60/40 portfolios change
dramatically, while that of Risk Parity is more stable. 60/40 would
under-perform unless the Sharpe ratio of stocks is near 0.6, which
implies an excess return of 9%.
Risk Parity (C)
In the second case, we change the Sharpe ratio of bonds from 0.0
to 0.6, while keeping that of stocks at 0.3. In this case, 60/40 would
out-perform, should the Sharpe ratio of bonds falls below 0.15.
Risk Parity (C)
Several observations are worth pointing out from this scenario
analysis. First, Risk Parity is always a better choice when the expected
Sharpe ratios are the same for both stocks and bonds. This is true
regardless of whether the overall level of the Sharpe ratio is 0.3 or 0.5.
Second, due to maximum diversification, Risk Parity is expected to
outperform 60/40 even when stocks offer higher risk-adjusted return
than bonds. Third, only when stocks have a much higher risk-adjusted
return than bonds, does 60/40 makes sense. Plan sponsors need to
carefully assess the probability of different scenarios in deciding
whether a 60/40 portfolio is still appropriate.
There is a well “documented” phenomenon in the scientific community
when it is faced with a new innovative idea. It evolves in four stages.
The response in the initial stage is “Rubbish!” The second stage is
“It is wrong but interesting nevertheless.” During the third stage, “It
might have some minor relevance.” And the last stage is “I told you
so!” Something similar seems to have happened to the Risk Parity
concept. It is gaining acceptance in the investment community.
Someone jokingly remarked to me that it seems that almost everyone
with whom I have ever worked is now involved in some type of Risk
I view this as a very good thing. As we pursue further research
and broader application of Risk Parity, we’d like to correct a few more
misconceptions on Risk Parity.
Fallacy 1: Risk Parity is a strategy that leverages the bond portion
of the portfolio to extend duration. This is a convenient operational
argument, however, it gives the wrong notion that one can attribute
overall portfolio leverage to some specific components. The correct way
to view Risk Parity portfolios with targeted risk is that we build the
most efficient mix of assets with Risk Parity and then scale portfolio
risk up or down by changing portfolio leverage.
Fallacy 2: Without limit the more asset classes the merrier. Herein,
is a misconception about diversification, in general.. For example, one
might be tempted to add other asset classes, such as high yield debt,
emerging markets debt, or real estate. These asset classes are already
highly correlated with equities, especially so during market crises.
The fundamental reason behind this is that they all have significant
exposure to downside risk of global economic growth. They tend
to suffer large losses together with the equity market, offering no
downside protection, while giving a false sense of diversification.
We believe that the Risk Parity Portfolios are well suited to meet
the needs of institutional investors. Investors must seek better alpha
sources as well as extract higher returns from their existing market
exposures in order to make up for significant portfolio shortfalls.
For many investors, the beta risk actually represents the majority
of their total risk budget. This element of portfolio construction is
unlikely to change as plans rebalance into risky asset classes to recover
asset values. The Risk Parity Portfolios provide a more efficient
alternative to traditional asset allocation in that they: 1) limit the
risk of overexposure to any individual asset class; 2) simultaneously
provide ample exposure to all of them; and 3) eliminate extraneous
allocations that do not provide additional risk diversification. With
Risk Parity portfolios, investors know that the diversification, along
with a required rate of return that they seek, is embedded in the risk
allocation of their efficient market portfolio. l
For more information, please contact Robert Job, CFA, Head
of Business Development, PanAgora Asset Management at 470
Atlantic Ave, 8th Floor, Boston, MA 02210 or email@example.com
or (617) 439-6359.
Assume stock and bond returns have an annual standard deviation of 15%
and 5%, respectively. Then, in terms of variance, stocks are nine times riskier
than bonds. Now, imagine we have six stock units of size 9 and four bond
units of size 1 in two separate baskets. In total, we have an equivalent of 58
units (i.e., ( 6 x 9) + ( 4 x 1)), of which 54 are from stocks. Fifty-four out of
58 is about 93%.
See Qian, Edward, E., “On the Financial Interpretation of Risk Contribution:
Risk Budgets Do Add Up.” The Journal of Investment Management, Fourth
Qian, Edward, E., “Risk Parity Portfolios”. PanAgora Asset Management,