"Counter-Point to Risk Parity Critiques"
Strong response to two criticisms of RP: the first regarding implementation, the second with the timing of RP. The paper is just three pages, but very clear and forceful, and is well worth the read.
Read the original:
Important Points for the RP Investor:
Page 1, left-hand column: Brief description of RP as a strategy. Peters mentions two constraints at work in traditional asset allocation: 1) no short positions, and 2) no leverage. Peters writes that RP keeps the first, but relaxes the second. “A risk parity portfolio is merely a more efficient ‘strategic’ portfolio in that it uses all of the same risk/return assumptions used to create a traditional asset allocation portfolio while relaxing the ‘long constraint’ to allow leverage.”
Page 1, right-hand column: Some of the criticisms of RP are methodological, that the use of leverage is inherently problematic. Peters makes three important clarifications regarding the proper use of leverage in an RP portfolio:
- some say that RP is just leveraging bonds, but since more bond exposure increased inflation risk, so you must have an inflation hedging component in a proper RP portfolio (NB: yes, this critique comes up a lot as a strawman in critiques of RP: “Too much in bonds, you’re not considering inflation risk.” IMO, an RP portfolio should have an allocation to gold/commodities to prepare for inflation risk.)
- Peters writes that not all assets should be leveraged. Corporate bonds have undesirable characteristics when leverage, namely increased counter-party risk that conforms to equity risk. His firm has a rule that any asset that “already has internal leverage (like stocks and corporate bonds) should not be leveraged again externally.” He notes that stocks have an average debt/equity ration of 2:1, so they are already leveraged. Peters and his form focus on leveraging government bonds, since they have no counterparty risk or liquidity risks which would be exacerbated through the use of leverage. “Leverage, in fact, merely puts sovereign bonds on an equal footing with stocks and corporate bonds whose higher risk and total return profiles are a result of ‘internal’ leverage as opposed to the ‘external’ leverage of sovereign bonds we can achieve in the futures market.”
- Commodities do not expect to have long-term excess return, and are included as an inflation hedge only. Therefore, a full allocation to commodities is not desirable (NB: this is the way i have treated them in the sample portfolios - definitely have them, but maybe not quite as much as the strict math based only on standard deviation would say).
Page 2, left-hand column: Starts a rebuttal to the idea that the 1941-1981 period shows that rising interest rates then would have made the strategy of leveraging treasuries a disaster. By implication, this can happen again, so RP would be foolish. Peters responds by pointing out the arithmetic flaw in the argument, and by showing that even with rising interest rates (and falling bond prices), treasuries still had a positive real return and an RP strategy would have been just fine for the period.
Page 3, left-hand column: Peters deals with another line of critique, that the time for RP is “not now” because X is going to happen to stocks, or Y is going to happen to bonds, or whatever. This is the Tactical Asset Allocation argument which comes from those who think they have a sense of what the future holds for markets and various asset classes. Based on that, if they foresee a bad decade for 10 year treasuries, they would argue for less allocated to that asset class. Their critique of RP then, is that by determining one’s asset allocation on other principles, the investor is handcuffed to this “static” asset allocation and not able to adjust to trends. This is Inker’s (2010) critique, though Peters doesn’t mention him. Peters responds that this critique also applies to 60/40 portfolios, isn’t specific to RP, and is more to do with your perspectives on whether asset class performance can be forecasted. And anyway, Peters writes, RP portfolios can be tactical. His firm’s RP portfolio (Essential Beta) shifts according to multi-year volatility periods, for example.
Page 3, right-hand column: Summary remarks at the end, which say that RP, like any investment strategy, can be poorly implemented, but that the concept is sound.
Other Resources Related to this Paper:
Ed Peters is Managing Partner at First Quadrant.
I'm not exactly sure what critique(s) drew the attention and ire of Mr. Peters, but it might be one of these by Ben Inker of GMO:
- The Hidden Risks of Risk Parity Portfolios (2010):
2. The Dangers of Risk Parity (2010) (paper is subscription only; I haven't been able to read it):