I was asked to contribute a chapter to a recent book published by the CFA Institute, Multi-Asset Strategies: The Future of Investment Management. I was honored by the invitation and happy to do so. Callan has a strong commitment to industry research as well as an ongoing connection to the CFA Institute; we have 42 associates who hold the right to use the Chartered Financial Analyst® designation and we eagerly support the CFA Institute as well as our associates who put in the hard work to advance their education and their careers by earning the designation.
My chapter, “Risk Parity: Silver Bullet or a Bridge Too Far?” built on the firm’s work and expertise on multi-asset class strategies. Risk parity is a category of investment strategies in which capital is allocated across asset classes so that each contributes an equal amount of volatility to the portfolio’s total volatility. Because the approach favors larger allocations to lower-returning asset classes, leverage is typically used to achieve the targeted return.
In the piece I tried to do four things:
- Provide a somewhat rigorous definition of risk parity from a theoretical standpoint using the modern portfolio theory (MPT) framework of Markowitz and Tobin
- Illustrate performance (both simulated and actual) of risk parity portfolios compared to traditional institutional investor portfolios
- Discuss the evolution of commercially available risk parity strategies
- Provide a high level assessment of the current use of risk parity strategies by institutional investors
This blog post provides a crib-note summary of my article; the full chapter is available on our website here, and the entire CFA Institute paper can be found here for those who have access to the CFA site.
Risk Parity, the Efficient Frontier, and the Use of Leverage
The first section of the paper uses Markowitz’s MPT framework (the efficient frontier and the capital market line) to help the reader understand the key differences between a traditional efficient mean-variance portfolio (like those employed by most institutional investors) and a risk-parity portfolio. The key differences are that the risk parity portfolio: employs far less equity; uses leverage to bridge the return gap that this produces; and theoretically generates a higher expected return per unit of risk (Sharpe Ratio). In short, the MPT framework reveals that the efficient risk parity portfolio is really just an extension of the efficient mean-variance portfolio, with the added degree of freedom created through the use of leverage. From an implementation standpoint this section provides practitioners with a theoretically consistent framework to ask practical questions to evaluate the efficacy of risk parity strategies.
In this section I look at both actual and simulated performance for both a risk parity portfolio and a traditional mean-variance portfolio that doesn’t employ leverage. I find that there is substantial evidence that the risk parity approach would have delivered superior risk-adjusted returns compared to a traditional unlevered mean-variance portfolio through recent history and across global markets. Countering this, however, I observe that the risk parity approach has the potential to significantly lag traditional portfolios for long periods of time during strong equity markets. This creates the potential for the strategy to underperform institutional peers that predominantly employ traditional equity-centric portfolios. From an implementation standpoint I conclude that risk parity is probably best used as a diversifying complement in a traditional institutional portfolio rather than as a substitute for one.
This section is a bit of an industry history lesson. The first risk parity strategy (the famous all-weather portfolio) was introduced to the industry by Bridgewater close to 20 years ago, and the term risk parity was coined about 10 years ago on the heels of the Global Financial Crisis. These types of products have significantly evolved since those early days. Many practitioners have adopted tactical approaches, shifting asset class allocations and leverage levels to respond to changes in their investing outlook. Others have strayed outside the simple asset classes to build their portfolios. Still others have abandoned the strict definition of “parity” and instead focused on optimizing risk-adjusted returns across their portfolios.
Use by Institutional Investors
The final section provides a high-level overview of the adoption of risk parity strategies by institutional investors. In practice, risk parity has been challenging to pursue at the policy level. Most institutional adoption has been through incremental allocations to the strategy, generally between 3% and 5% of the total portfolio.
That’s the article in a nutshell. Hopefully you will have the time to take a look at the full article. For more on the subject, my colleagues Mark Andersen and Jason Ellement recently published a white paper on multi-asset class strategies for the Callan Institute; interested readers can find it here.