"Understanding Risk Parity"
Fantastic overview of RP, with focus on its improvement over typical portfolios. Contains handy comparisons of a simple Risk Parity portfolio and a standard 60/40 portfolio over various time periods. Great read as an introduction to RP; very readable and succinct.
Read the original:
Important Points for the RP Investor:
Page 2: Discussion of why Risk Parity was gaining in popularity at that time (late 2000s/early 2010s): consistent long-term results and better performance during market declines of 2008-9. Authors argue that RP's performance can be explained by the lack of concentrated risk in equities, which took such a downturn in the years prior to the paper. They write: “Traditional portfolios give the illusion of diversification when in fact they have concentrated exposure to equity markets.”
Pages 2-3: Authors describe RP portfolios as intending to
Page 3: Exhibit 2 shows risk-adjusted performance of equities, bonds, and commodities is similar between 1971 and 2009, with Sharpe ratios in the .25 to .3 range for each. “Regardless of asset class, investors have been paid, on average, about the same amount to bear risk - which is why a portfolio constructed to the weight of each asset class similarly makes sense in the long run.”
Pages 3-6: Comparison of standard 60/40 portfolio with a simple Risk Parity portfolio, which has been constructed to match the 60/40’s annualized standard deviation of 10.1% (for the time period 1971-2009). Long story short: RP outperformed by 1.7% in those 39 years. Authors also break out eight notable events/phases in the market since 1971, and find that RP outperformed the 60/40 in six of them. This is a helpful discussion, as it highlights when RP might be expected to exceed the 60/40 and when it might be expected to trail.
Page 5: Helpful diagram showing Sharpe ratios for the three asset classes and the RP portfolio in each of the four decades of the study. Each asset class has had its high and its low points, but the RP performs well throughout.
Pages 6-7: This section seems more geared to professional investment managers, but the DIY investor can still glean some important insights on how to put an RP portfolio in place. 1) Is based on three asset classes, though others can be used, just watch out for correlation with others; 2) the “passive” approach to RP is to equalize risk, as the name implies, though you could seek higher tactical allocations to a given source of risk, if you wish; 3) Can change the volatility targets by using leverage to match an 80/20 or 100% equities portfolio (NB: this is exactly what the sample portfolios in this blog do!).
Page 8: Authors address the question of how RP fits within an investment scheme. Discuss a core/satellite approach and the treatment of RP as an “alternative” asset class. This section connects to a question often posed about RP: is it the portfolio? Or is it part of the portfolio? In my view, RP is the portfolio, since if you had one RP portfolio and then one equity portfolio, you really wouldn’t have actual diversification, you’d just have a mental accounting trick that made you think you were diversified.
The three authors of this paper are Brian Hurst, Bryan Johnson, and Yao Hua Ooi of AQR (Applied Quantitative Research), a very successful investment management firm known for its use of quantitative strategies. AQR has also advocated used risk parity approaches, as well, in its funds and is a prolific contributor to investment research: