disparity? risk parity vs. the 60/40 portfolio · number of providers of risk-parity portfolios...

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Disparity? Risk Parity vs. the 60/40 Portfolio O ne of the most fascinating pastimes in the investment business is witnessing the creative ability of the sellers of ideas to use mathematics to support their conclusions despite the obvious lessons of reality. A current example of this can be seen in marketing materials from a number of providers of Risk-Parity Portfolios (RPP), which appear to have allowed managers’ zealousness for gathering assets to interfere with their ability to portray a complete picture of the strengths and weaknesses of this approach. While RPP can be a meaningful addition for some investors, its representation as a solution without peer does not match how the capital markets operate in the practical world. As is so often the case, these strategies’ applicability and viability are greatly dependent upon both implementation and timing. This issue of Investment Insight reviews the genesis and purpose of RPP, and examines its viability as a strategy. The Genesis, Purpose and Evolution of Risk Parity After every downdraft in equity beta returns, there comes a hue and cry for reduced exposure to the evil forces of volatile stocks. The period following the 2008 financial crisis was no different, except this time there arose a “new” solution, known popularly as Risk Parity. (As is often the case, this “new” approach had roots going back 20 years, and the “newness” was only in the marketing.) In this approach, the investor diversifies not by optimizing volatility for a given level of return, but rather by balancing the volatility contributions of the asset classes to total portfolio risk. Risk Parity supplicants define risk simply as overall portfolio volatility — a somewhat naïve and narrow construct. This created a problem for this strategy, as balancing risk meant, over long periods, substantially lower expected returns. The Risk-Parity Engineers (RPEs), after realizing their mistake, sought to solve this pretty important shortcoming by leveraging the fixed-income portion of the portfolio to increase the returns. Next, however, the RPEs realized that if there was substantial inflation, the leveraged fixed-income allocation could really be harmed (another expression for this would be “drawdowns,” or what we used to call “losses”). The RPEs’ answer? Let’s add commodity exposure. Satisfied that the back tests now indicated that this addition would be acceptable, they compared the results to the classic portfolio of 60 percent U.S. stocks and 40 percent U.S. bonds (60/40 portfolio), with favorable results, and declared RPP Version 3.0 “the answer.” Strategy Shortcomings We see several issues with this approach. First, why use the 60/40 stock-and-bond mix for comparison? Does anyone really have that allocation anymore? Most investors have exposure to a variety of markets globally, including real estate, emerging markets, Treasury inflation- protected securities (TIPS) and more. Using 60/40 as the comparison for marketing purposes is simply inadequate and misleading, as we shall see later in this piece. Interestingly, as they compared the result, did the 60/40 portfolio get a shot at employing leverage as well? No, actually. OK, how about adding in a basket of commodities — did the 60/40 portfolio have that included? Again, no. Does it feel as though these back tests are designed to prove a conclusion already reached? One recent report indicated that the provider (an important word here, as the “proof” comes from someone who gets a fee if people buy what they are proving) has recre- ated markets back more than 100 years to demonstrate that RPP works. It is clear In This Issue: n The Genesis, Purpose and Evolution of Risk Parity n Strategy Shortcomings n Putting Risk Parity’s Promise to the Test n A Market-Theory Perspective n Why the Risk-Parity Approach Has Value n Conclusion September 2014 [Because] most investors have exposure to a variety of markets globally... . using 60/40 as the comparison for marketing purposes is simply inadequate and misleading.HOT TOPIC

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Page 1: Disparity? Risk Parity vs. the 60/40 Portfolio · number of providers of Risk-Parity Portfolios (RPP), which appear to have allowed managers’ zealousness for gathering assets to

Disparity? Risk Parity vs. the 60/40 Portfolio

One of the most fascinating pastimes in the investment business is witnessing the creative ability of the sellers of ideas to use mathematics to support their conclusions despite the

obvious lessons of reality. A current example of this can be seen in marketing materials from a number of providers of Risk-Parity Portfolios (RPP), which appear to have allowed managers’ zealousness for gathering assets to interfere with their ability to portray a complete picture of the strengths and weaknesses of this approach. While RPP can be a meaningful addition for some investors, its representation as a solution without peer does not match how the capital markets operate in the practical world. As is so often the case, these strategies’ applicability and viability are greatly dependent upon both implementation and timing. This issue of Investment Insight reviews the genesis and purpose of RPP, and examines its viability as a strategy.

The Genesis, Purpose and Evolution of Risk ParityAfter every downdraft in equity beta returns, there comes a hue and cry for reduced exposure to the evil forces of volatile stocks. The period following the 2008 financial crisis was no different, except this time there arose a “new” solution, known popularly as Risk Parity. (As is often the case, this “new” approach had roots going back 20 years, and the “newness” was only in the marketing.) In this approach, the investor diversifies not by optimizing volatility for a given level of return, but rather by balancing the volatility contributions of the asset classes to total portfolio risk. Risk Parity supplicants define risk simply as overall portfolio volatility — a somewhat naïve and narrow construct.

This created a problem for this strategy, as balancing risk meant, over long periods, substantially lower expected returns. The Risk-Parity Engineers (RPEs), after realizing their mistake, sought to solve this pretty important shortcoming by leveraging the fixed-income portion of the portfolio to increase the returns. Next, however, the RPEs realized that if there was substantial inflation, the leveraged fixed-income allocation could really be harmed (another expression for this would be “drawdowns,” or what we used to call “losses”). The RPEs’ answer? Let’s add commodity exposure. Satisfied that the back tests now indicated that this addition would be acceptable, they compared the results to the classic portfolio of 60 percent U.S. stocks and 40 percent U.S. bonds (60/40 portfolio), with favorable results, and declared RPP Version 3.0 “the answer.”

Strategy Shortcomings

We see several issues with this approach. First, why use the 60/40 stock-and-bond mix for comparison? Does anyone really have that allocation anymore? Most investors have exposure to a variety of markets globally, including real estate, emerging markets, Treasury inflation-

protected securities (TIPS) and more. Using 60/40 as the comparison for marketing purposes is simply inadequate and misleading, as we shall see later in this piece. Interestingly, as they compared the result, did the 60/40 portfolio get a shot at employing leverage as well? No, actually. OK, how about adding in a basket of commodities — did the 60/40 portfolio have that included? Again, no. Does it feel as though these back tests are designed to prove a conclusion already reached? One recent report indicated that the provider (an important word here, as the “proof” comes from someone who gets a fee if people buy what they are proving) has recre-ated markets back more than 100 years to demonstrate that RPP works. It is clear

In This Issue:n The Genesis, Purpose

and Evolution of Risk Parity

n Strategy Shortcomings

n Putting Risk Parity’s Promise to the Test

n A Market-Theory Perspective

n Why the Risk-Parity Approach Has Value

n Conclusion

September 2014

“ [Because] most investors have exposure to a variety of markets globally... . using 60/40 as the comparison for marketing purposes is simply inadequate and misleading.”

HOT

TOPIC

Page 2: Disparity? Risk Parity vs. the 60/40 Portfolio · number of providers of Risk-Parity Portfolios (RPP), which appear to have allowed managers’ zealousness for gathering assets to

Investment Insight n September 2014 n page 2

that defined benefit pension plans have long time horizons, but does anyone want to wait that long? Do we believe that the capital markets and global macroeconomic environments today reflect those of a century ago?

The best evidence of the recent unadmitted shortcomings of RPP strategies lies in the new buzzword: Dynamic RPP. This means the asset manager actively allocates between the vari-ous portfolios in order to enhance return and avoid the downside. Call it market timing, global tactical asset allocation, or “dynamic,” the poor 60/40 portfolio again takes it on the chin. Can we add the same “dynamic” return to the 60/40 results and show that comparison? It is prob-ably also safe to assume that the “dynamic” wasn’t tested for a century either. In any case, the introduction of this “new-and-improved” concept is likely driven by the fact that what investors were originally sold hasn’t quite worked out all that well. Rather than admitting that this strat-egy did not live up to expectations, the investor is told, “Well, that wasn’t our best idea. Try this one instead.”

Let’s summarize the comparison we are being asked to make in order to validate RPP as an approach, as shown in the table to the right.

Wow! No wonder RPP looks so good. Segal Rogerscasey Canada actually received a pitch book the other day with an RPP strategy’s performance, compared to the poor 60/40 mix, that had 11 asset classes or subclasses, including TIPS, high yield, emerging market debt and real estate investment trusts (REITs) — with a key bullet point that trumpeted: “RPP outperforms.....!” The material went on to note that the reason for this was that RPP was “bet-ter diversified.” That is a pretty novel concept.

Putting Risk Parity’s Promise to the Test

Perhaps at this point, since none of the sellers of RPP are likely to do so, we should briefly review just how a basic RPP strategy would have done since it became in vogue. We know the big push for these products began post-crash, of course, so let’s start the performance clock running on 1/1/10. Many managers introduced the products sooner, but the buying cycle does take a little time, after all. By our calculations, a traditional portfolio (meaning, a well-diversified global portfolio of stocks and bonds, with credit, and some modest allocation to alternatives) would have returned 9.09 percent on an annualized basis between 1/1/10 and 12/31/13. An RPP portfolio over the same timeframe would have earned 6.86 percent on an annualized basis. That is a spread of 2.23 percent per year over four years. If we think about that in dollar terms on a $500 million USD portfolio, that would equate to a relative dollar loss of more than $56 million USD. Pretty meaningful. For some reason, left to the readers’ imagination, this seems to be miss-ing from marketing material.

Another test of a good idea is the degree to which the believers implement it. The RPP solution is rarely more than 10 percent of any institution’s portfolio and generally less than 5 percent. In terms of balancing total plan risk, which is the stated goal of RPP, this allocation would barely move the needle. If the purpose of RPP is to improve efficiency, a goal sought at the total portfolio level, then why so little? A small wager is a sign of low confidence in the hand held, for there is no sandbagging in this game.

A Comparison of Characteristics of Old RPPs and “New-and-Improved” RPPs

New-and- Characteristics The Old Way Improved RPPs

Investments Stocks Stocks Included Bonds Bonds Commodities and more

Rebalancing Static Dynamic Strategy

Testing Reality Back testing Approach

Page 3: Disparity? Risk Parity vs. the 60/40 Portfolio · number of providers of Risk-Parity Portfolios (RPP), which appear to have allowed managers’ zealousness for gathering assets to

Investment Insight n September 2014 n page 3

A Market-Theory Perspective

Finally, we turn to the basic fundamentals of capital market theory. Why should an investor receive the same level of risk to reward for each asset class? Stocks, bonds, commodities and their sub-asset classes don’t have the same fundamental drivers. Not all traditional asset classes have the same Sharpe Ratio1 over time, or during interim periods. Therefore, why should an investor take equal risk when it is not rewarded? The graphs on this page show the ratio of risk to reward for traditional asset classes. Graph 1 above illustrates that many differences persist for some time. Graph 2 shows the average of the data presented in Graph 1. One can see there are many differences that persist for some time.

Source: Investment Metrics, data through April 2014. (Availability of historical data differs by asset class.)

Graph 1: 10-Year Rolling Sharpe Ratio for Traditional Asset Classes

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International Developed Fixed Income (Unhedged)High-Yield Bonds

Emerging Market Debt

Global Fixed Income

Long-Term Fixed Income U.S. Equity International Developed

Equity (Unhedged)

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Graph 2: Average 10-Year Rolling Sharpe Ratio for Traditional Asset Classes, January 1970-April 2014 where data was available

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1 Sharpe Ratio is a measure of excess return per unit of risk.

Page 4: Disparity? Risk Parity vs. the 60/40 Portfolio · number of providers of Risk-Parity Portfolios (RPP), which appear to have allowed managers’ zealousness for gathering assets to

Investment Insight n September 2014 n page 4

This leads us to consider why an investor would not choose to lever up or lever down the maximum-Sharpe portfolio. Depending on the level of the risk-free rate in relation to risky assets, choosing portfolios along the efficient frontier, while it may be efficient, can lead to selections with lower Sharpe Ratios depending on risk and return objectives. If the investor has the ability and willingness to have substantial commitments to alternatives, including commodities, and to use leverage,

then perhaps the optimal solution is to determine the best globally diversified portfolio in terms of risk/return tradeoff (as measured by Sharpe or some other mechanism) and apply leverage as needed to achieve target goals. The notion that the contribu-tion to volatility from each asset class should simply be equal, at parity, has no empirical foundation.

The level of the risk-free rate may also lead to different maximum-Sharpe portfolios in relation to RPPs. The following two examples illustrate the impact of a risk-free rate of 2 percent versus 4.4 percent with U.S. Equity (9.2 percent return, 19 percent risk) and Core Fixed Income (4.8 percent return, 6 percent risk). Under both risk-free-rate scenarios, the RPP allocations and risk are the same (but have different Sharpe Ratios).

The maximum-Sharpe portfolios are very different — with a 2 percent risk-free rate leading to a 20 percent allocation (39 percent risk) to U.S. Equity and 80 percent allocation (61 percent risk) to Core Fixed Income, and with the 4.4 percent risk-free rate leading to a 59 percent allocation (95 percent risk) to U.S. Equity and 41 percent allocation (5 percent risk) to Core Fixed Income. Graph 3 below and Graph 4 on page 5 illustrate these differing outcomes.

Equity Weight

Core FI Weight

Risk

Return

Sharpe

MC Equity

MC Core FI

MC % Equity

MC % Core FI

Risk Parity

24% 76% 6.59% 5.86% 0.58 3.30% 3.30% 50.00% 50.00%

Maximum Sharpe

20% 80% 6.26% 5.68% 0.59 2.44% 3.82% 39.01% 60.99%

Source: Investment Metrics

Graph 3: Risk-Free Rate of 2%

“ The notion that the contribution to volatility from each asset class should simply be equal, at parity, has no empirical foundation.”

Efficient Frontier Leveraged Optimal Sharpe

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Page 5: Disparity? Risk Parity vs. the 60/40 Portfolio · number of providers of Risk-Parity Portfolios (RPP), which appear to have allowed managers’ zealousness for gathering assets to

Investment Insight n September 2014 n page 5

Why the Risk-Parity Approach Has ValueOf course it makes sense to think about what the contributors to volatility are in a portfolio, but making them equal isn’t “the” solution. Of course leverage can be applied to improve efficiency, but there are many ways to do that — including RPP and options strategies and a host of down-

side protection strategies. Of course adding commodities to a portfolio can increase inflation protection. And without a doubt, a dynamic approach to asset allocation will change the distribution of possible outcomes (perhaps positively or perhaps negative-ly). None of these statements could be considered a revelation or a revolution. What should be worrisome is the lengths to which RPEs will go to defend their solution rather than educate and illustrate fairly, with responsible comparisons.

There are, despite comments above, several elements of the RPP movement that are relevant and valid for investors. First, another set of voices extolling the virtues of diversification is always welcome. The notion of putting most of one’s assets in a

single basket (or even two), particularly with an excessive emphasis on the source of volatility being in only one of those assets, should be shouted down once and for all. Second, a rational conversation about the role of leverage and commodities within the context of managing risk is also pertinent and important. Finally, to consider and assess the impact and exposure of certain factor-driven constructs such as inflation is a discussion that investors should engage in as part of their asset allocation decision.

“ Of course it makes sense to think about what the contributors to volatility are in a portfolio, but making them equal isn’t ‘the’ solution.”

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Graph 4: Risk-Free Rate of 4.4%

Equity Weight

Core FI Weight Risk

Return

Sharpe

MC Equity

MC Core FI

MC % Equity

MC % Core FI

Risk Parity

24% 76% 6.59% 5.86% 0.22 3.30% 3.30% 50.00% 50.00%

Maximum Sharpe

59% 41% 11.59% 7.40% 0.26 10.95% 0.63% 94.56% 5.44%

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Sharpe R

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Page 6: Disparity? Risk Parity vs. the 60/40 Portfolio · number of providers of Risk-Parity Portfolios (RPP), which appear to have allowed managers’ zealousness for gathering assets to

Investment Insight n September 2014 n page 6

Copyright © 2014 by The Segal Group, Inc. All rights reserved.

Segal Rogerscasey Canada provides consulting advice on asset allocation, investment strategy, manager searches, performance measurement and related issues. The information and opinions herein provided by third parties have been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed. Investment Insight and the data and analysis herein is intended for general education only and not as investment advice. It is not intended for use as a basis for investment decisions, nor should it be construed as advice designed to meet the needs of any particular investor. Please contact Segal Rogerscasey Canada or another qualified investment professional for advice regarding the evaluation of any specific information, opinion, advice or other content. Of course, on all matters involving legal interpretations and regulatory issues, investors should consult legal counsel.

Questions? Contact Us.

For more information about our views on risk parity and other investment strategies, contact your Segal Rogerscasey Canada consultant or one of the following investment professionals:

Segal Rogerscasey Canada provides investment solutions and consulting advice to corporations, plan sponsors and retail clients across Canada. For more information about the firm, visit http://www.segalrc.com/canada/.

To receive Segal Rogerscasey Canada publications as soon as they are available online, register your e-mail address via http://www.segalrc.com/register/.

Segal Rogerscasey Canada is a member of The Segal Group (www.segalgroup.net), which is celebrating its 75th anniversary this year, and the Global Investment Research Alliance (http://www.gir-alliance.com/).

Conclusion

In the final analysis, RPP strategies in general qualify for the same characterization as so many other solutions marketed post any dramatically negative market environment: Interesting, but not magi-cal. Implementable, but not immune to cycles or timing. Purposeful, but not for everyone every day. Executable, but subject to implementation shortfall. And, again, as is so common, sold almost as a religion when truly it is only another option in the ever-expanding set of ideas, solutions and strate-gies that may assist investors in achieving their goals, if done well and, usually, at the right time.

New ideas are great, they challenge us and move us forward, but, as is often the case, much of what is termed “new and improved” may be only situational and sales-driven. Beware of any presentation where a rear-view-mirror look at performance is the dominant introduction. And this, for our part, is our greatest concern for RPP and so many other like ideas — sales dominates substance and the past is projected to be prologue. n

“ Beware of any presentation where a rear-view-mirror look at performance is the dominant introduction.”

1 Tim Barron 203.621.3633 [email protected]

1 Frank Salomone 203.621.3625 [email protected]

1 Ruo Tan 416.642.7792 [email protected]