Investors are typically counselled to diversify capital across asset classes in an effort to reduce risk.
In light of this, it could be something of a surprise to learn just how concentrated a traditionally diversified portfolio may be in terms of its sources of risk.
Risk parity – the concept of attempting to achieve diversification by sources of risk – is gaining wider attention.
While there are numerous risks involved with investing, “risk” as we refer to it in this paper means volatility or standard deviation and does not specifically encompass other sources of investment risk, such as international investing risk.
“Risk parity” is a term used to describe an investment strategy that seeks to balance the sources of risk in a portfolio. The easiest way to envision this concept may be to consider it in the context of a traditional, diversified portfolio. For many investors, this portfolio is represented by defined percentage allocations across stocks and bonds. Such a “balanced” portfolio, for example, will often allocate 50% of its assets to stocks and 50% to bonds in an effort to achieve diversification. However, research indicates that this equal allocation of investment capital does not necessarily equate to being diversified by risk.
This is because stocks tend to exhibit four-to-five times more volatility than bonds. So, while the weighting of a “balanced” portfolio appears to be even and equal, the investment in equities carries significantly greater risk than the investment in bonds. Exhibit 1 highlights the disparity.
Exhibit 1: Balanced Portfolio Allocations
Source: SEI; Equities = S&P 500 Index (representing 500 U.S. large companies), Fixed Income = Barclays U.S. Aggregate Index (representing U.S. bonds), 20 years monthly data (1993 to 2012)
Risk Parity: Balanced Risk
Risk parity investment strategies seek to diversify risk. In order to achieve this, these strategies assume that asset classes (such as stocks and bonds) should contribute equally to the level of risk in a portfolio. For example, based on volatility over the past 20 years, a portfolio would only need to allocate 17% to U.S. stocks and 83% to U.S. bonds to make the contributions to risk equal, as seen in Exhibit 2.
Source: SEI; Equities = S&P 500 Index, Fixed Income = Barclays U.S. Aggregate Index; analysis used monthly data (1993 to 2012)
Risk Parity—Beyond the Basics
At the simplest level, a risk parity portfolio manages to achieve equal contributions to risk across various asset classes. In addition, risk parity strategies tend to allocate beyond stocks and bonds in an effort to provide upside growth (when markets rise) and downside mitigation (when markets fall) through various economic scenarios, as shown in Exhibit 3.
Exhibit 3: Exposures for Varying Economic Regimes
For example, a hypothetical risk parity strategy may include global stocks in addition to domestic stocks for growth-orientated environments, and inflation-sensitive assets (i.e., commodities) for inflationary environments. These assets are not always accounted for in less-diversified portfolios.
Once the asset-class allocations are established, maintaining equal contribution to risk is accomplished by monitoring the level of volatility of each asset class bucket and actively adjusting the portfolio’s exposure based on rising or falling volatility. When the volatility of an asset rises, its contribution to risk is maintained by reducing its allocation to the portfolio. If all assets experience an increase in volatility (as in the 2008 credit crisis), exposures across each bucket will be reduced and the assets shifted to cash.
Proponents of risk parity believe that a balanced risk allocation can produce higher and more consistent returns than a traditional capital-allocated portfolio over time. The benefits of the strategy may include reduced allocations to and reliance on the stock market, a more diversified set of exposures during varying economic scenarios, and the potential for enhanced risk and reward characteristics.
No investment strategy is without risk. Seeking to allocate assets in a way that keeps one asset class from dominating performance can be beneficial for risk-management purposes. However, compared to a traditional portfolio, broad diversification beyond stocks and bonds can lead to performance differences. Reduced exposures to more volatile, and potentially higher returning, asset classes can result in lower volatility but also lower returns.
Risk parity strategies can be structured to target higher risk (and reward) profiles while balancing risks across asset classes. In these instances, the strategy will apply a form of leverage (which involves its own set of investment risks) to lower volatility assets (such as bonds) to better equate their risks (and reward) with other, higher- returning asset classes.
Glossary of Financial Terms
• Risk and reward: The risk and reward relationship, generally speaking, is such that the higher the potential reward of an investment, the greater the likelihood of price fluctuations (one of the risks).
• Leverage: Leverage refers to the degree to which an investor or company is using borrowed money to finance activities. For example, a highly leveraged company would have a significant amount of debt relative to its equity. Leverage can help increase returns, but can also increase risk in that it may be more difficult to make payments on debt.
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SEI sources data directly from the following vendors: Factset, MSCI Barra, Russell, TOPIX, FTSE, Barclays and BofA Merrill Lynch. Where appropriate, returns in base currencies are converted to the relevant currency using WM Reuters 4pm Spot rates.