As we continue our review of the main portfolio models, a practitioner innovation deserves our attention: It all started when Ray Dalio and Bob Prince, from Bridgewater, launched their All Weather Fund in 1996, and led to the birth of the risk-parity approach.
The All Weather does not correspond to the active strategies of the hedge fund Bridgewater that is impossible to replicate by individual investors without the IT infrastructure and technical expertise of the global macro hedge fund. All Weather aims at designing a long-term and robust portfolio with minimal maintenance and the qualitative approach of the All Weather is a good orientation for any investor. Since it is simpler than newer risk parity approaches or other models, it is a good starting point for beginner/intermediate investors.
Until the end of the last century, traditional asset allocation focused primarily on equities and used bonds to control risks (60% equity and 40% bonds is often quoted as the “traditional asset allocation” and is a key benchmark to compare multi-asset strategies). Unlike the traditional asset allocation and the mean–variance model (optimization that targets a specific return with a minimal level of risk – see the article of May 2021), a risk parity strategy expects each asset class to contribute equally to portfolio risk, regardless of its expected return. The allocation to different asset classes is not an optimization that targets a specific return with a minimal level of risk but should generate a portfolio in which the contribution to portfolio risk of each asset class is equal, regardless of its expected returns.
As Bob Prince mentioned in “Risk Parity Is about Balance”, the objective is to “collect the risk premium as consistently as possible, by minimizing risk due to unexpected changes in the economic environment.”
Different asset classes possess excess return over the risk-free rate and react differently to the two main macroeconomic drivers of the business cycle: growth and inflation: economic activity (growth) and its pricing (inflation) determine the value of assets, leading to four risk scenarios and four corresponding subportfolios in order to allocate funds. Different asset classes will do differently well depending to those four particular environment: when (1) inflation rises, (2) inflation falls, (3) growth rises, and (4) growth falls – relative to expectations. The main asset classes to be favored according to the situation are :
(1) Inflation rises: IL bonds, commodities
(2) Inflation falls: Equities, nominal bonds
(3) Growth rises: Equities, commodities
(4) Growth falls relative to expectations: Nominal bonds, IL bonds
No investor is capable to predict whether markets will discount more or less the two economic drivers (growth and inflation) in the future. Because you do not know the future, you should choose to invest in a balanced way for the long-run. You can spread your assets equally over different scenario outcomes based on their contribution to the total portfolio risk. Risk parity means that the portfolio balances so that each asset class contributes the same potential for losses.
The implementation of a risk parity strategy involves the following steps and decisions:
(1) Selection of the risk metric and the target level of risk: e.g., standard deviation appears to be the risk measure of choice;
(2) Selection of the asset classes to be included in the portfolio: a risk parity strategy can be done through a passive strategy (recommended) using low-cost collective investment vehicles such as exchange-traded funds or an active strategy such as one making use of a factor model (not recommended here);
(3) Estimate the risk contribution of each selected asset class: e.g., standard deviations of the selected exchange-traded funds ;
4) Construct an equally risk-weighted portfolio with no leverage (i.e., an unlevered risk parity portfolio; a levered risk parity portfolio and bets are possible but not recommended here). First, the risk budget is allocated into the four compartments: To simplify the investment process, 25% of risk can be allocated to each of these four categories. Then, within each risk budget compartment, asset classes are suballocated (e.g. on an even basis for simplification), based on their exposure to the four growth–inflation dimensions.
The implementation seems easy, but some practical issues arise: First, due to their lower volatility, bonds tend to be over-allocated. The approach also suggests a valuation-neutral approach but extra caution is necessary in the current monetary environment. For example, IL bonds would be an asset of choice for a situation of lower growth and higher inflation but the yields of all bonds are currently unattractive: The iShares Global Inflation Linked Govt Bond UCITS ETF returns less than 1%. Finally, while the sensitivity of commodities to inflation can usually offset the effect on bonds, other factors may not have the impact expected based on historical asset correlations. Bonds will perform best during times of disinflationary recession, stocks will perform best during periods of growth, but during some crisis stocks and bonds can move in the same direction. Risk parity strategies (in particular passive ones) do not show any immunity when this occurs.
In practice, there are many variants of the risk parity strategy (diverse selection of the asset classes, different risk measures, active or passive approach). Since the maximization of return is a key objective beside risk minimization, S. Deo and R. Nakisa proposed that weighting for each asset class corresponds to its Sharpe ratio (Sharpe parity approach). A higher Sharpe ratio will lead to a higher asset allocation (in the same proportion) and I personally prefer such an approach to the risk parity model since it accounts for the maximization of returns. However, the risk-parity analysis gives me insight into the portfolio’s risks and sensitivity to scenarios of growth and inflation. Even if you do not construct your portfolio on the risk-parity basis (which I neither do), it will give you valuable insights on how market factors may affect your wealth under different environments.
Sources: Risk Parity: The Democratization of Risk in Asset Allocation, The Journal of Portfolio Management, Volume 47, Issue 5, 2021, Francesco A. Fabozzi, Joseph Simonian, and Frank J. Fabozzi “Risk Parity Is about Balance.” Bridgewater Associates, LP, 2011, Bob Prince https://www.bridgewater.com/research-and-insights/the-all-weather-story "When Risk Parity Goes Wrong", 2013 Stephane Deo and Ramin Nakisa
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