Risk Parity Resources: Asness (1996)

"Why Not 100% Equities"

Short, provocative case in favor of a leveraged, balanced portfolio over an unleveraged, unbalanced portfolio. Should be read in context with Ray Dalio’s work about leveraged Risk Parity and Asness’s later piece (with Frazzini and Pedersen) about aversion to use of leverage.

Read the original (download button over on the right):

Why Not 100% Equities
In a 1994 article “College and University Endowment Funds: Why Not 100% Equities?” Richard H.

Important Points for the RP Investor:

This is essentially a rebuttal piece to an argument made by Richard Thaler and J. Peter Williamson recommending that endowment funds use a 100% Equity portfolio. In the T&W piece, they present multi-decadal data showing the out performance of all equities compared to an all-bond portfolio and a 60/40 blend. Seems straight-forward enough, for sure.

Asness answers their point by pointing out that T&W are essentially mixing two arguments: 1) “a recommendation that endowments take more risk than a 60/40,” and 2) “a recommendation about how to implement this riskier strategy (i.e. 100% equities).” It’s a point that, honestly, 95% of investors have never even thought about. Equities outperform bonds, so just have more equities if you want to do better - that's the very conventional wisdom. Most people have a sense of risk as an on/off switch, where bonds are the “off” and equities the “on,” and the only way to get higher returns is to have more ons than offs. T&W are basically saying to endowment officials: “The history shows you can have more switches on than you have had” and Asness is basically responding, “Well, you may not want more risk, and if you do want more risk, there are better ways to do it.”

The middle section of the paper is Asness’s backtests where he introduces the performance of a levered 60/40: one that uses 55% additional leverage to increase the holdings of both stocks and bonds, but still maintains the relative balance between them. If you are willing to handle equity-like volatility, then the backtests show you'd  get better returns with leveraging a balanced portfolio. You could think of this as a “93/62,” with the extra allocation coming from borrowing an additional 55% of the portfolio. Asness then uses the same data set, and finds these returns:

Asness's answer to those same endowment officials: If you are comfortable with 20% standard deviation of a 100% equity portfolio, then you would have had better performance by using a levered version of a more balanced portfolio!

This key observation connects back to Risk Parity principles and deserves amplification. That idea that levered and balanced beats unlevered and unbalanced is reminiscent of Ray Dalio’s investment thesis as well, as explained in his 2011 paper (actually a reprint of a paper from 2004) called “Engineering Targeted Risks and Returns.”:

Top 10 Risk Parity Resources: #6... Dalio (2011)
A “look under the hood” for constructing RP portfolios. Seems written for other industry professionals, but isn’t overly technical for the average investor. The whole paper is worth reading, but especially pages 4 through 7.

This idea has been covered elsewhere by yours truly, such as with the discussion of the two paths of Risk Parity. In the first, investors prioritize total safety to truly diversify their portfolios (but accept the possibility of lower returns). In the scond, investors can use modest amounts of leverage to boost the returns of that stable but modestly performing portfolio, bringing them up to the level of more aggressive equity portfolios.

Two Paths of RP
RP approaches are diverse, but at a basic level, follow one of two paths. They are not necessarily risky nor safe, but do provide a framework to balance assets at different degrees of total risk.

The remaining paragraphs of the Asness paper are devoted towards anticipating some common questions investors may have: 1) What about other concepts of risk, especially in terms of worst case scenarios?, 2) What if you can’t or won’t lever?, and 3) What if you have a long time horizon? Asness walks the reader through the topics., and its a short enough paper that its better just top read the paper if you're keen.

Regarding the second question, readers may also want to read his 2011 paper (co-written with Andrea Frazzini and Lasse Pedersen) on “Leverage Aversion and Risk Parity.” There, the authors posit that one of the strengths of risk parity is that investors are generally hesitant to use leverage with investing, resulting in relatively lower prices for lower performing assets that could become more profitable through the use of leverage. Unwilling to do that, investors bid up the prices on assets that deliver higher returns without leverage (equities), neglecting assets with more favorable valuations in terms of return per unit of risk. It’s a fascinating paper and part of my Top 10 Risk Parity Resources:

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

The paper wraps up with some commentary on approaching investing, regardless of whether someone wants the risk/return profile of 100% equities, a levered 60/40, or whatever. Asness writes that one flaw in the Thaler and Williamson approach is to conflate two separate issues, and then make decisions that don’t have room for alternative perspectives. Asness writes:

In answer to Thaler and Willamson’s question, “Why Not 100% Equities?”, I argue that the two steps necessary in creating a portfolio must be examined separately. Step one is constructing the feasible set of efficient portfolios (portfolios that are investable and have the most expected return per unit of risk). Step two is choosing which of these portfolios to own (i.e. what risk/return trade-off maximizes utility).

In the end, it’s a convincing argument (for a Risk Parity aficionado!), and is helpful for untangling the various elements of portfolio construction approaches. Well worth a read.

Turns out that the basic point espoused by Asness has actually become an ETF that investors can buy: WisdomTree’s US Efficient Core Fund (NTSX). This is basically straight out of the Asness paper - it holds 90% in a S&P 500 index fund and then uses the other 10% as collateral to purchase future contracts for US Treasuries at a rate of 6:1, making this effectively a 90/60 portfolio (indeed, that was its previous name). I do not own NTSX myself, but it is one of the funds I point people towards when they have questions about risk parity. Here is a primer on the fund, along with two non-US versions:

Relatedly, this blog post by Jeremy Schwartz from 2021 is an update of Asness’s findings that stretches the timeframe to 2020.

An Update to Cliff Asness s Study on the Benefits of a Levered 60 40 | WisdomTree ETF Blog
News for investors seeking higher risk-adjusted returns: Jeremy Schwartz discusses

Schwartz finds that the logic behind a levered 60/40 is even stronger with 25 years of additional data.

The takeaway point is the same: a levered 60/40 has the same standard deviation as a 100% equity portfolio (ok, a smidge higher), but delivers higher return. In this case, it is 1.3%, compared to .8% in the backtest to 1994. Risk Parity for the win!