Risk Parity: How to Invest for All Market Environments
Readable and practical book about Risk Parity that lays out the basic tenets, walks the reader through how to construct a RP portfolio, and discusses RP’s limitations, as well as its strengths. Not exactly geared towards the DIY investor, but still helpful.
Read the original:
Important Points for the RP Investor:
There are only two (!) mainstream books on Risk Parity (the other one is Risk Parity Fundamentals by Edward Qian), and this is the one to read first, saving Qian’s for when you really want to be in the weeds. Since this is a book, there is so much more to cover in a summary, and too much to put into a bullet point list. Here is a quick preview of the chapters:
Chapter 1: Conceptual framework for RP. Emphasis that RP portfolios are primarily about balance. Explains roots of RP in Markowitz’s MPT, and how in a balanced portfolio of uncorrelated asset streams, the path of several of them combined is smoother than the path of any of the streams. Also, a discussion of risk as it relates to portfolios.
Chapter 2: Building a balanced portfolio. Two main tasks: 1) select the right asset classes, meaning finding asset classes that thrive in particular market environments and that are either negatively or minimally correlated with each other; 2) structuring each to have similar returns. On this second point, we see here that Shahidi is addressing a slightly different audience than that of DIY investors, as he primarily focuses on futures as the primary way to leverage the portfolio.
Chapter 3: Equities. First of five chapters on asset classes in a balanced portfolio, this one discusses the conceptual framework for the role of equities in a portfolio, as they are suited for times of rising growth and falling inflation. Also comments composition of the equity portion, with recommendation of a rough split between US and non-US equities, and a dedicated portion to Emerging Markets.
Chapter 4: Treasuries. Suitable for falling growth and falling inflation, with preference of long-term treasuries over short-term. This section also anticipates some of the frequent criticisms of RP portfolios that give “too much allocation to non-performing bonds,” and is worth a read to help understand the big picture.
Chapter 5: Treasury Inflation-Protected Securities (TIPS). This type of bond, designed to thrive in inflationary eras, is certainly controversial in the small (but growing) sub-culture of DIY Risk Parity investors. Good to read, even if you agree with Vasquez and Risk Parity Radio that the benefits of TIPS are dubious. Shahidi argues that they work in environments of falling growth and rising inflation, or the exact opposite of treasuries. I can’t say I’m fully sold on this argument (which is why there are no TIPS in any of my sample portfolios), but anyway, he presents it here.
Chapter 6: Commodities. The fourth recommended asset class, and suited for times of rising growth and rising inflation. The interesting element here is the preference for the stocks of commodity producers, rather than through the more typical route of commodity ETFs based on futures. Also discusses gold in this chapter, for which he favors ETFs that hold actual bullion.
Chapter 7: Other Asset Classes. With the discussion of commodities, Shahidi has covered the four asset classes he recommends and the economic environments in which they can be expected to drive positive portfolio return:
This is followed by short snippets on the following asset classes from a risk parity point of view: factor & sector-based equity funds, non-US government bonds, corporate bonds, municipal bonds, commercial real estate, private equity, hedge funds, cryptocurrencies, and cash.
Chapter 8: Portfolio Summary. Reveal of model Risk Parity portfolio: 25% equities, 25% commodities (which consists of 15% commodity-producer equities, 10% physical gold), 35% Long-Term Treasury bonds, and 35% Long-Term TIPS. This is also the composition of Shahidi's firm's RP fund: the ETF RPAR (see below for some more resources on RPAR). On pages 96 and 97, there is also mention of a non-leveraged version and a more aggressive version with 44% leverage, as opposed to 20%. Update: there is no a more leveraged version of RPAR, called UPAR.
Chapter 9: Portfolio Historical Returns. Analysis of the Risk Parity portfolio over three time periods: since 1998 (when TIPS were introduced), since 1970, and since 1926. Not surprisingly, the RP portfolio shines in comparison to the standard 60/40 while matching its risk metrics.
Chapter 10: The Timeliness of Risk Parity. Discusses the outlook for risk parity given current conditions. The point here is that uncertainty abounds, as it always does, and the best way to handle it is to pursue a balanced portfolio that doesn’t depend on you guessing what the future will hold.
Chapter 11: The Rebalancing Boost. Discussion of rebalancing in a RP portfolio, which is especially important when combining volatile but uncorrelated assets. In essence, this ensures the investor is buying low and selling high when they exchange their over-performing assets for capital to buy the under-performing ones.
Chapter 12: Efficient Implementation. Notes on issues related to putting a Risk Parity portfolio into practice: simplicity, costs, liquidity, tax considerations, transparency, and leverage. Subtext of this chapter is that it’s the theoretical explanation of, and advertising for, his firm's ETF, RPAR.
Chapter 13: When does Risk Parity underperform? I really enjoyed this chapter, as I’m always on the lookout for the flaws of RP that I may be glossing over in my excitement over its promise. Shahidi looks at the past 50 years, finds that the model RP portfolio has had 15 cases of negative excess returns (meaning, compared to just keeping your money in cash), just 5 that were more than 10% lower than cash, and just one that was 15% worse (1981). Commonalities are that RP underperforms when the cash rate rises unexpectedly (and the unexpected part is key) and in times of panic, when investors flee everything to get into cash, no matter what. The good news is that both of these situations tend to be short-lived. This chapter is definitely worth reading in its entirety.
Chapter 14: FAQ. A grab bag chapter where Shahidi discusses other aspects of Risk Parity (such as whether RP is part of the portfolio or is the portfolio, and expands on other points mentioned earlier (rebalancing, the role of bonds, etc.). Highlight here was the question: If Risk Parity is so obvious, why isn’t it more popular? This is a question of mine, as well, and I call it the Groucho Marx critique ("I wouldn't want to belong to any club that would have me as a member").
In sum, Shahidi's book is well worth the read if you are interested in a broad discussion of risk parity principles, implementation, and analysis at a high, yet still accessible level. Most valuable are chapters 1, 8, and 13, and then 11 if you are interested in the issue of rebalancing.
Shahidi is co-Chief Investment Office at Evoke Advisors. Here is an interview with him and the other Co-CIO discussing RPAR.
Further documentation on RPAR: