Top 10 Risk Parity Resources: #8... Asness et al. (2012)

"Leverage Aversion and Risk Parity"

Important paper for two reasons: 1) provides some of the theoretical rationale for why RP works (leverage aversion); 2) conveys data of three tests of whether RP works. They find that RP’s success is not likely due to data mining by proponents. Well worth a read.

Read the original:

This paper is held by JSTOR, so read this to learn how to sign up, then click below for the paper:

Leverage Aversion and Risk Parity on JSTOR
The authors show that leverage aversion changes the predictions of modern portfolio theory: Safer assets must offer higher risk-adjusted returns than riskier as...

Important Points for the RP Investor: Asness, Frazzini, and Pedersen aim to provide a more theoretical explanation of why RP is successful. They argue that prior work on RP has presented results, but not offered much of an explanation of why. Specifically, they focus on the issue of leverage.

Page 47: description of what RP is, along with a chart showing RP’s superior performance compared to a 60/40 portfolio and to a value-weighted market portfolio since 1926.

Page 49: Work by Frazzini and Pedersen in 2010 showed that “if some investors are averse to leverage, low-beta assets will offer higher risk-adjusted returns and high-beta assets will offer lower risk-adjusted returns.” To back up a second, low-beta and high-beta assets mean those that are either not very much or very much correlated with the market. Think long-term treasuries as an example of low-beta, and various types of equities as high-beta, since they tend to match the stock market as a whole. Also, the phrase “risk-adjusted” is key, because leverage can be used to buy more of those assets which offer better risk-adjusted returns.

Page 49: discussion of the Capital Asset Pricing Model (CAPM) helping to explain theoretically how leverage can be used to “move up” the tangency portfolio (Readers unfamiliar with this section when reading may want to follow the link about CAPM above as well as read up on Modern Portfolio Theory, the Efficient Frontier, and the Capital Market Line).

Page 50: Authors lay out the theory of “leverage aversion” and its effect on portfolio construction.

"Because some investors choose to overweight riskier assets in order to avoid leverage, the price of riskier assets is elevated, or equivalently, the expected return on riskier assets is reduced. In contrast, the safe assets…trade at low prices. Hence, investors who are able and willing to apply leverage can earn high risk-adjusted returns by…overweighting safer assets.”

This is the key to Risk Parity's efficiency as a portfolio.

Page 51: Even without the preceding section about the theory behind RP’s success, the section that begins here where the authors offer empirical evidence for RP’s performance is enough to make the paper worth the read. They offer three empirical tests of RP: 1) A long sample involving US stocks and bonds back to 1926; 2) A broad sample involving global stocks, US bonds, credit, and commodities from 1973; and 3) a global sample involving stocks and bonds from 11 countries since 1986.

Page 52-55: Discussion of the empirical tests, with charts summarizing the findings. Some highlights: Authors find that, if anything, the period from 1926-2010 was generally in favor of equities over bonds, yet “bond heavy” RP portfolios still outperformed. Page 55 has a great graph showing a RP portfolio beat the 60/40 in terms of Sharpe ratios in all eleven countries in the survey.

Page 55: Concluding discussion on robustness of “leverage aversion” to explain high risk-adjusted permanence of RP portfolios. Final sentence is a ringing endorsement:

“Our finding that RP investing is yet another instance of this theory working out of sample greatly enhances our confidence that Risk Parity’s superiority to traditional methods of strategic asset allocation is real and important and not a figment of the data."

This paper was authored by Cliff Asness, Andrea Frazzini, and Lasse Pedersen, all of AQR (Applied Quantitative Research), a very successful investment management firm known for its use of quantitative strategies. Asness is its co-founder, managing partner, and CIO, and frequently appears in the media. This is a great interview with Asness on The Rational Reminder:

Episode 93: Cliff Asness from AQR: The Impact of Stories, Behaviour and Risk — Rational Reminder
No one credible ever said that investing was a simple endeavour. It might have some simple guidelines, that if followed are more likely to yield positive results, but the ins and outs of the markets, decisions and their impacts, movements and crashes are never straightforward one-dimensional cases.