Risk Parity Resources: Obregon et al. (2018)

"Risk Parity"

Another summary of Risk Parity. This one focuses on two things: 1) How RP differs from traditional asset allocation approaches (based on Mean Variance Optimization); 2) Leverage. Worth reading for these two discussions.

Read the original:

Important Points for the RP Investor:

Page 1: Following a brief discussion that defines RP, authors draw a contrast between RP and traditional asset allocation strategies based on the theory of Mean Variance Optimization (MVO). MVO comes out of Modern Portfolio Theory as pioneered by Harry Markowitz and James Tobin, and, defined simply, aims to create “efficient” portfolios with high expected returns for a given level of risk. In practice, creating an MVO portfolio usually involves substantial allocation to equities to drive growth, then tempered by an allocation to a low-risk asset such as cash or short-term treasuries. Investors comfortable with risk may hold 90% of their assets as equities; more conservative investors may be 50/50, or whatever. Interested readers can also check out my explanation of MVO here.

Page 2: Authors  point out that one drawback is that MVO depends on accurately predicting risk levels of inputs. In contrast, with RP, an investor relies on long-term assessments of the riskiness of asset classes, and is less dependent on estimating the inputs for expected risk.

Page 4: Authors include their version of a RP portfolio, and it’s a bit unusual, with perhaps the least equity exposure of any I have seen: 15% equities, 56% rate sensitive bonds (by which they mean a core bond fund of intermediate to long-term treasuries, mortgage-backed securities, and  high-grade corporate bonds), and then 29% in TIPS.

Page 5: With this stable but most likely unprofitable portfolio in mind, the authors pivot to a discussion of leverage to bring it into the range of a traditional allocation (60/40). For the levered portfolio, they use 243% additional exposure to bring the RP portfolio to the riskiness of the traditional portfolio. The comparison of results is below:

Page 6: They include an interesting chart showing the sources of risk in the three portfolios, as well.

Pages 6-10: Discussion of various issues related to RP portfolio construction: the choice of assets to invest in, leverage, volatility targeting, interest rate and equity risk, active risk, and derivatives infrastructure and knowledge. This section seems targeted to professional investment managers.

Pages 10-12: Historical performance. The authors compare the three portfolios, and find that the levered portfolio has outperformed, especially in turbulent times. They note that periods of rapidly rising rates have not been good for a Risk Parity approach.