"The Hidden Risks of Risk Parity Portfolios"
Criticism of Risk Parity portfolios and philosophy from the perspective of a value-tilted, traditional asset allocation perspective. Worth reading to get a sense of how RP is viewed, and to see if Inker’s criticisms are valid. May want to read Ed Qian’s response paper afterwards.
Read the original:
Important Points for the RP Investor:
To summarize the article, Inker critiques Risk Parity on three broad lines of argument: 1) RP confuses volatility with risk, and doesn’t pay enough attention to the tail-end risk of having to liquidate your assets in a RP portfolio; 2) Includes asset classes that (Inker believes) will have zero or negative return in the future; 3) some asset classes in a RP portfolio have negative skew which is not fully captured by the backtesting process, and this may leave RP approaches in for a shock.
Before getting to these critiques, Inker does compare a traditional 60/40 portfolio with a Risk Parity portfolio, and finds that the RP has been better on both return and volatility grounds. It’s an odd way to begin a critique of RP, but nevertheless, Inker does try to build the argument that RP’s success are illusory.
Inker then ends the paper by transitioning to an argument against passive-investing, and a bit confusingly, calls RP a flawed passive approach. This critique was simply weird (I don’t necessarily associate RP with passive investing, though it could be, but hasn’t he heard of Bridgewater?).
And now, my thoughts:
Inker’s argument is representative of the type you get when you read pieces from people who make their living selecting the “right” investments and getting you to pay then for their expertise. The general argument is along the lines of: “I predict that X,Y, and Z, will happen, and you do not prepare at all for X, Y, or Z - therefore, you are incorrect.” The paper is littered with predictions, and then Inker takes RP to task for failing to conform to his predictions. Towards the end of the paper, on page 6, Inker makes it clear why – he thinks RP is beholden to ineffective guidelines when really, smart equity selection (and selectors!) is what is needed. He writes, “Such passivity makes little sense in a world where asset class valuations, and therefore the risk and opportunity sets available to investors, change so much from year to year.” Invest with him, and he’s confident he’ll find those opportunities, I’m sure. Make sure you pass on 2% to Inker for the expertise.
To give an example, consider Inker’s thoughts on bonds as an asset class. Bonds did great from 1982 to 2008, thereby bringing along more bond-heavy (and even leveraged) RP portfolios along for the gains. In 2010, though, Inker definitively declares that bond prices will tank, taking RP portfolios along with them. He writes on page 5 that “falling bond yields are almost certainly gone.” Yet the actual history of ten-year treasuries since March of 2010 has basically been…falling bond yield. Other predictions in Inker’s paper are that commodities are basically extinct as an asset class (actually Inker would have been right for some of the following decade, before a stellar 2020 into 2021), and that equities will, now and forever, reign supreme.
To give Inker his due, I do think that his third criticism of Risk Parity - that there is negative skewness (meaning “the bads are badder than the goods are good”) in portfolios that the backtesting can’t capture. Writing just after the financial crisis, Inker makes the point that sometimes things can look fine (in 2007) only for us to later realize there were things under the surface that were definitely not fine. Inker’s point is that when you have leverage, you are magnifying those risks (yes, I think every RP practitioner would concede that) beyond your control. One could ask what he thinks about most people’s decision to buy a house, or point out that there is no mention of the term negative correlation in his paper, so he probably hasn’t considered how risks are connected. I also wish he would have suggested a better way to backtest, or a better way to think about hidden risks, though, since the “there be dragons lurking” argument would seem to apply to lots of investors. But no matter, this critique has merit. It’s a good thing to keep in mind, and not get too cocky or too leveraged, which probably amount to basically the same thing.
If you’ve read this far, then also be sure to check out Edward Qian’s rebuttal to Inker, titled “Investment Insight: No More Risk Parity Debate?” from April 2014. Qian’s response is partly to this Inker paper, plus another one that Inker wrote in 2011 (that I haven’t been able to get a copy of since it is behind a lot of expensive paywalls). The main part of the paper is Qian’s test of the asset class predictions by Inker and his company, and whether a Risk Parity portfolio or a traditional 60/40 portfolio would do better. Qian finds that, even if you use Inker’s forecasts, a RP portfolio outperforms. To add insult to injury, Qian then compares what actually happened in the years since those forecasts were released. Yet another “L” for Inker - the RP portfolio achieved 4% higher returns than a 60/40, with the same annualized standard deviation.
You may also want to read my summary of the Ed Peters paper. I believe Peters is pushing back against Inker, and even if he isn't, Peters takes us some of Inker's arguments here.