"Risk Parity: Common Fallacies"
Addresses ten common criticisms of a risk parity approach, describing and answering them in turn. A good read, as the authors provide the reader with a deeper understanding of RP in the process of debunking the critiques.
Read the original:
Important Points for the RP Investor:
Important Points for the RP Investor: The paper is broken up into ten sections that address particular lines of criticism against RP. Perhaps a table shows it best:
Pages 1 - 2: The use of volatility as a risk measure is flawed. Using volatility as the only measure of risk would certainly be limiting, but it is widely accepted as a good starting point. Different RP approaches and practitioners use other, additional measures of risk.
Pages 3 - 4: Risk Parity Strategies are built on historical volatility. Not necessarily, and again the variety of approaches to RP demonstrates that RP is not bound to just historical volatility. “Risk has many dimensions - regimes, jumps, time horizons, and non-quantifiable components among others - and it is therefore an art and a science to bring all the pieces together.”
Pages 4 - 5: Risk Parity excessively loads up on fixed income. Such a critique, though, isn’t really an argument against risk parity - it is an argument that the critic has “a different tactical view rather than believing there is a fundamental flaw in the theory behind a particular strategy’s construction.” In this case, the criticism is that the future will be different from the past in a way predicted by that critic. They may be correct in the end, but the real question is to identify the better portfolio ex ante.
Pages 5 - 6: Risk Parity Portfolios are not actually at risk parity. Well, yes, because there is no one single definition of RP or one exact portfolio. Different investment managers have different definitions and models of risk, and investors have different goals, time horizons, and varying aversions to tail risk. There is no “one size fits all” approach, so there are going to be discrepancies.
Pages 6 - 7: Risk Parity strategies do not reflect the fundamental value of assets. Again, this argument is really a stalking horse for the argument that the critic has a different fundamental valuation of assets, not that the RP is inherently flawed. If a particular version of a RP portfolio is found lacking in understanding price multiples, yields, or other measures, then a different RP portfolio could reflect those. Again, not a criticism of RP per se.
Page 7: Risk Parity is trend following - it sells the losers and buys the winners. Not necessarily. To begin with, some RP portfolios can be passive and not involve much rebalancing; they need not change their allocations based on every minute change in volatility profiles. Second, asset weights in RP portfolios are based on relative volatilities in assets, not absolute volatility, and it is just as possible that an RP practitioner is selling the winners to buy the losers.
Pages 7 - 8: Leverage is bad. Leverage can be used, or not, depending on investor goals. RP begins from a position of balancing risk, and if higher returns are desired, leverage can be used strategically to increase return while still keeping risk levels appropriate.
Page 8: Risk Parity is illiquid. No, not necessarily. A good RP portfolio is a diverse one, and if liquidity is preferred, it can be constructed out of liquid assets like ETFs, futures contracts, and Treasuries.
Page 8: Risk parity omits risks like government intervention. If the risks in the future are similar to those faced in the past, then a RP portfolio would incorporate those just as much as any other approach. If it is truly a novel source of risk, then RP portfolios might fail just as much as any other approach, as well.
Pages 8-9: The benchmark for a RP portfolio should be 60/40, cash, or …Interesting & provocative point here: the authors argue that really, a RP portfolio should be the benchmark for the others, such as the 60/40. They write that “the 60/40 portfolio actually has very strong opinions embedded within it and is therefore ‘active’ compared to risk parity.
Page 9: The paper closes with an argument on behalf of RP as an “effective and more efficient way to generate returns from an asset allocation portfolio.” They continue: