Bank of America Brings the Risk Parity Debate to a Boil
Risk Parity is having a moment.
For us, the fuse was lit in August 2016 when Bank of America Merrill Lynch released a research note suggesting that Risk Parity investment strategies represented a substantial source of systemic risk in global markets. The report began:
“…While the drawdowns in US Treasuries, US equities, and ultimately risk parity portfolios were small and short-lived, the latent risk remains worth monitoring, as (i) leverage is still near max levels across a variety of risk parity parametrizations, (ii) bond allocations are historically elevated, and (iii) markets continue to be skeptical of a 2016 Fed hike.”
In a single sweeping statement, BAML conjured three fundamental – but misguided – demons that have haunted the risk parity concept since Edward Qian coined the term over a decade ago. To paraphrase BAML’s fear-mongering:
- Risk parity strategies often employ leverage to reach higher volatility targets, with commensurately higher expected returns;
- Some strategies alter their leverage factor through time in response to changes in market conditions, such that the strategies are more highly levered during low volatility periods.
- When these risk parity strategies move to de-lever in the face of rising volatility and cross-asset correlations, this will trigger a systemic market event.
- Risk parity strategies typically hold a larger allocation to bonds than stocks, since bonds have lower volatility, so they are especially vulnerable to periods that are hostile to bonds, such as rising rate environments.
Why Historical Context Matters
These notions have persisted because of a fundamental misunderstanding about the nature of risk parity. That’s why we founded a web portal devoted to the concept, and published a 2,500 word point-by-point refutation of BAML’s research note in August 2016.
The reality of risk parity is quite different from the perception. Shall we count the ways?
- Risk parity is about ensuring that diverse assets, which exhibit different natural risk characters, and respond in uncorrelated ways to inflation and growth shocks, have an equal opportunity to express their unique qualities in a portfolio.
- Risk parity takes no position on the relative opportunity for returns across global assets, but expresses the simple view that investors should be rewarded with returns in proportion to risk.
- Consistent with the concept of the Capital Market Line, leverage is used to amplify returns, by increasing exposure to the entire maximally diversified portfolio;
- Risk parity strategies come in two broad formats, which broadly serve to offset one another’s systemic effects.
- Risk parity has delivered highly competitive performance, across evolving combinations of growth and inflation, than other popular portfolios.
This last point may be difficult to believe, given that, with the benefit of hindsight, a U.S. 60/40 portfolio has been such a strong performer over the past century or more. However, we took the time to examine the performance of a globally diversified risk parity strategy over the past nine decades. We discovered that risk parity produced higher returns than a U.S. 60/40 portfolio, with smaller maximum losses, when scaled to the same level of risk.
Many investors miss the significance of this point because their lifespans have been dominated by a period of U.S. exceptionalism. The fact is, U.S. stocks and bonds are the best performing financial assets over the past century. We know this to be true in hindsight, but we obviously can’t know it to be true in the future. A U.S. oriented 60/40 portfolio may be engineered to do well if the future looks exactly like the past. But for investors who are uncertain about how the future might unfold, their best option is to maximize the opportunity for diversification. And that’s what a global risk parity portfolio is all about.
Risk Parity Isn’t a Silver Bullet
This is not to say that Risk Parity is a silver bullet. In rising rate environments, performance is worse than falling rate environments. But the comparisons are important here: what investment strategy are you comparing Risk Parity against, over what time frame, and in what economic environments? Even more to the point, given what we know about the importance of structural diversification, how confident are you that your current strategy optimally matches tomorrow’s yet-to-be-revealed growth and inflation climate?
This is not a rhetorical exercise. Depending on your investment edge and level of confidence, it may well be appropriate to make some active wagers. But for the remainder of your portfolio, you will be hard pressed to find an investment method better suited to navigate uncertainty than a global risk parity portfolio.
You can learn more about ReSolve Global Risk Parity and our other adaptive strategies designed to thrive in changing environments at ReSolve Online Advisor.
And yet, the debate rages on. Which is why we were honored to present our most recent Risk Parity research through RealVision Television, a leading research portal for institutional investors featuring exclusive content from some of the world’s most successful managers and leading research minds.
In our presentation, we expand our historical case study by examining Risk Parity relative to a US 60/40 portfolio from 1928-2016. Discover our surprising revelations here. (Editorial Note: This is a paid site for which we receive no compensation if you join. You can get a free 7-day look by registering.)
