Risk parity
Encyclopedia
Risk parity is an alternative approach to investment portfolio management which focuses on allocation of risk rather than allocation of capital. The risk parity approach asserts that when asset allocations are adjusted (leveraged or deleveraged) to the same risk level, the risk parity portfolio has the same expected rate of return as the portfolio with traditional asset allocations.
Risk parity can also be a generalized term that denotes a variety of investment
systems and techniques that utilize its principles. The principles of risk parity are applied differently according to the investment style and goals of various financial managers and yield different results.
Some of its theoretical components were developed in the 1950s and 1960s but the first risk parity fund, called the All Weather fund, was pioneered in 1996. In recent years many investment companies have begun offering risk parity funds to their clients. The term, risk parity, came into use in 2005 and was then adopted by the asset management industry. Risk parity can be seen as either a passive or active management strategy.
Interest in the risk parity approach has increased since the late 2000s financial crisis
as the risk parity approach fared better than traditionally constructed portfolios, as well as many hedge funds. Some portfolio managers have expressed skepticism about the practical application of the concept and its effectiveness in all types of market conditions but others point to its 15 year track record, and extensive simulations and stress-testing, as an indication of its potential success.
of 60% stock
s and 40% bonds
which carries 90% of its risk in the stock portion of the portfolio (see illustration). The risk parity approach attempts to equalize risk by allocating funds
to a wider range of categories such as stocks, government bonds, credit-related securities and inflation
hedges
(including real assets, commodities, real estate and inflation-protected bonds), while maximizing gains through financial leveraging
. According to Bob Prince, CIO at Bridgewater Associates
, the defining parameters of a traditional risk parity portfolio are uncorrelated assets, low equity risk, and passive management
.
Some scholars contend that a risk parity portfolio requires strong management and continuous oversight to reduce the potential for negative consequences as a result of leverage and allocation building in the form of buying and selling of assets to keep dollar holdings at predetermined and equalized risk levels. For example, if the price of a security goes up or down and risk levels remain the same, the risk parity portfolio will be adjusted to keep its dollar exposure constant. On the other hand some consider risk parity to be a passive approach, because it does not require the portfolio manager to buy or sell securities on the basis of judgments about future market behavior.
The principles of risk parity may be applied differently by different financial managers, as they have different methods for categorizing assets into classes, different definitions of risk, different ways of allocating risk within asset classes, different methods for forecasting future risk and different ways of implementing exposure to risk. However, many risk parity funds evolve away from their original intentions, including passive management. The extent to which a risk parity portfolio is managed, is often the distinguishing characteristic between the various kinds of risk parity funds available today. Moreover, some investors use risk parity as a neutral benchmark measurement, while they actively manage their asset allocation using information regarding market forecasts and/or other techniques.
winner, Harry Markowitz
introduced the concept of the efficient frontier
into modern portfolio theory in 1952. Then in 1958, Nobel laureate James "Bill" Tobin concluded that the efficient frontier
model could be improved by adding risk-free investments and he advocated leveraging a diversified portfolio to improve its risk/return ratio. The theoretical analysis of combining leverage and minimizing risk amongst multiple assets in a portfolio was also examined by Jack Treynor in 1961, William Sharpe
in 1964, John Lintner
in 1965 and Jan Mossin
in 1966. However, the concept was not put into practice due to the difficulties of implementing leverage in the portfolio of a large institution.
According to Joe Flaherty, senior vice president at MFS Investment Management
, "the idea of risk parity goes back to the 1990s". In 1996, Bridgewater Associates launched a risk parity fund called the All Weather asset allocation strategy which attempted to "achieve consistent performance" and equalize risk by correlating diversification (such as global inflation-linked bonds and global fixed income assets) with exposure to different economic drivers, such as inflation and economic growth. The initial impetus for the All Weather fund was to establish a family trust for the founder of Bridgewater Associates. Although Bridgewater Associates was the first to bring a risk parity product to market, they did not coin the term. Instead the term, risk parity was first used by Edward Qian, of PanAgora Asset Management, when he authored a white paper in 2005. The term was later co-opted by the asset management industry and evolved into a portfolio investment category. In time, other firms such as AQR Capital
, Aquila Capital
(2004), Northwater, Wellington
, Invesco, First Quadrant, Putnam Investments
, ATP
(2006), PanAgora Asset Management (2006), AllianceBernstein
(2010) and the Clifton Group (2011) began establishing risk parity funds.
, there was an increased interest in risk parity, first among institutional investors in the United States and then in Europe. USA investors include the Wisconsin State Investment Board which has invested hundreds of millions in the risk parity funds of AQR and Bridgewater Associates. The financial crisis of 2007-2010 was also hard on equity-heavy and Yale Model portfolios, but risk parity funds fared reasonably well.
According to a 2011 article in Investments & Pensions Europe, the risk parity approach has "moderate risks" which include: communicating its value to boards of directors; unforeseen events like the 2008 market decline; market timing risks associated with implementation; the use of leverage and derivatives and basis risks associated with derivatives. Other critics warn that the use of leverage and relying heavily on fixed income assets may create its own risk. Portfolio manager, Ben Inker has criticized risk parity for being a benchmarking approach that gives too much relative weight to bonds when compared to other alternative portfolio approaches. However, proponents of risk parity say that its purpose is to avoid predicting future returns. Inker also says that risk parity requires too much leverage to produce the same expected returns as conventional alternatives. Proponents answer that the reduced risk from additional diversification more than offsets the additional leverage risk and that leverage through publicly-traded futures and prime brokerage financing of assets also means a high percentage of cash in the portfolio to cover losses and margin calls. Additionally Inker says that bonds have negative skew
, (small probability of large losses and large probability of small gains) which makes them a dangerous investment to leverage. Proponents have countered by saying that their approach calls for reduced exposure to bonds as volatility increases and provides less skew than conventional portfolios.
Risk parity advocates assert that the unlevered risk parity portfolio, is quite close to the tangency portfolio, as close as can be measured given uncertainties and noise in the data. Theoretical and empirical arguments are made in support of this contention. One specific set of assumptions that puts the risk parity portfolio on the efficient frontier
is that the individual asset classes are uncorrelated and have identical Sharpe ratio
s. Risk parity critics rarely contest the claim that the risk parity portfolio is near the tangency portfolio but they say that the leveraged investment line is less steep and that the levered risk parity portfolio has slight or no advantage over 60% stocks / 40% bonds, and carries the disadvantage of greater explicit leverage.
Despite criticisms from skeptics, the risk parity approach has fared well in the marketplace and has seen a "flurry of activity" in recent years. During the period 2005 to 2009 several company's began offering risk parity products including: Barclays Global Investors, First Quadrant, Mellon Capital Management and State Street Global Advisors
. A 2011 survey of institutional investors and consultants suggests that over 50% of America-based benefit pension and endowments and foundations are currently using, or considering, risk parity products for their investment portfolios. Companies like AQR Capital and Bridgewater Associates have attracted clients such as the Wisconsin State Investment Board, The Pennsylvania Public Schools Employees’ Retirement System and the Alaska Permanent Fund Corp to their risk parity funds.
Risk parity can also be a generalized term that denotes a variety of investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
systems and techniques that utilize its principles. The principles of risk parity are applied differently according to the investment style and goals of various financial managers and yield different results.
Some of its theoretical components were developed in the 1950s and 1960s but the first risk parity fund, called the All Weather fund, was pioneered in 1996. In recent years many investment companies have begun offering risk parity funds to their clients. The term, risk parity, came into use in 2005 and was then adopted by the asset management industry. Risk parity can be seen as either a passive or active management strategy.
Interest in the risk parity approach has increased since the late 2000s financial crisis
Late-2000s financial crisis
The late-2000s financial crisis is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s...
as the risk parity approach fared better than traditionally constructed portfolios, as well as many hedge funds. Some portfolio managers have expressed skepticism about the practical application of the concept and its effectiveness in all types of market conditions but others point to its 15 year track record, and extensive simulations and stress-testing, as an indication of its potential success.
Description
Risk parity is a conceptual approach to investing which attempts to provide a lower risk and lower fee alternative to the traditional portfolio allocationAsset allocation
Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.-Description:...
of 60% stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s and 40% bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
which carries 90% of its risk in the stock portion of the portfolio (see illustration). The risk parity approach attempts to equalize risk by allocating funds
Asset allocation
Asset allocation is an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investors risk tolerance, goals and investment time frame.-Description:...
to a wider range of categories such as stocks, government bonds, credit-related securities and inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
hedges
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
(including real assets, commodities, real estate and inflation-protected bonds), while maximizing gains through financial leveraging
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
. According to Bob Prince, CIO at Bridgewater Associates
Bridgewater Associates
Bridgewater Associates is an American investment management firm founded by Ray Dalio in 1975 and is reported to be the world's largest hedge fund company with $122 billion in assets under management. The company has 270 clients including pension funds, endowments, foundations, foreign governments...
, the defining parameters of a traditional risk parity portfolio are uncorrelated assets, low equity risk, and passive management
Passive management
Passive management is a financial strategy in which an investor invests in accordance with a pre-determined strategy that doesn't entail any forecasting...
.
Some scholars contend that a risk parity portfolio requires strong management and continuous oversight to reduce the potential for negative consequences as a result of leverage and allocation building in the form of buying and selling of assets to keep dollar holdings at predetermined and equalized risk levels. For example, if the price of a security goes up or down and risk levels remain the same, the risk parity portfolio will be adjusted to keep its dollar exposure constant. On the other hand some consider risk parity to be a passive approach, because it does not require the portfolio manager to buy or sell securities on the basis of judgments about future market behavior.
The principles of risk parity may be applied differently by different financial managers, as they have different methods for categorizing assets into classes, different definitions of risk, different ways of allocating risk within asset classes, different methods for forecasting future risk and different ways of implementing exposure to risk. However, many risk parity funds evolve away from their original intentions, including passive management. The extent to which a risk parity portfolio is managed, is often the distinguishing characteristic between the various kinds of risk parity funds available today. Moreover, some investors use risk parity as a neutral benchmark measurement, while they actively manage their asset allocation using information regarding market forecasts and/or other techniques.
History
The seeds for the risk parity approach were sown when economist and Nobel PrizeNobel Prize
The Nobel Prizes are annual international awards bestowed by Scandinavian committees in recognition of cultural and scientific advances. The will of the Swedish chemist Alfred Nobel, the inventor of dynamite, established the prizes in 1895...
winner, Harry Markowitz
Harry Markowitz
Harry Max Markowitz is an American economist and a recipient of the John von Neumann Theory Prize and the Nobel Memorial Prize in Economic Sciences....
introduced the concept of the efficient frontier
Efficient Frontier
The efficient frontier is a concept in Modern portfolio theory introduced by Harry Markowitz and others. A combination of assets, i.e. a portfolio, is referred to as "efficient" if it has the best possible expected level of return for its level of risk...
into modern portfolio theory in 1952. Then in 1958, Nobel laureate James "Bill" Tobin concluded that the efficient frontier
Efficient Frontier
The efficient frontier is a concept in Modern portfolio theory introduced by Harry Markowitz and others. A combination of assets, i.e. a portfolio, is referred to as "efficient" if it has the best possible expected level of return for its level of risk...
model could be improved by adding risk-free investments and he advocated leveraging a diversified portfolio to improve its risk/return ratio. The theoretical analysis of combining leverage and minimizing risk amongst multiple assets in a portfolio was also examined by Jack Treynor in 1961, William Sharpe
William Forsyth Sharpe
William Forsyth Sharpe is the STANCO 25 Professor of Finance, Emeritus at Stanford University's Graduate School of Business and the winner of the 1990 Nobel Memorial Prize in Economic Sciences....
in 1964, John Lintner
John Lintner
John Virgil Lintner, Jr. was a professor at the Harvard Business School in the 1960s and one of the co-creators of the Capital Asset Pricing Model....
in 1965 and Jan Mossin
Jan Mossin
Jan Mossin was a Norwegian economist. Born in Oslo, he graduated with a siv.øk. degree from the Norwegian School of Economics in 1959...
in 1966. However, the concept was not put into practice due to the difficulties of implementing leverage in the portfolio of a large institution.
According to Joe Flaherty, senior vice president at MFS Investment Management
MFS Investment Management
MFS Investment Management is an American-based global asset manager, formerly known as Massachusetts Financial Services. It is owned by Sun Life Financial of Canada, with subsidiary headquarters in Boston, Massachusetts and offices worldwide. MFS was founded in 1924 and is one of the oldest asset...
, "the idea of risk parity goes back to the 1990s". In 1996, Bridgewater Associates launched a risk parity fund called the All Weather asset allocation strategy which attempted to "achieve consistent performance" and equalize risk by correlating diversification (such as global inflation-linked bonds and global fixed income assets) with exposure to different economic drivers, such as inflation and economic growth. The initial impetus for the All Weather fund was to establish a family trust for the founder of Bridgewater Associates. Although Bridgewater Associates was the first to bring a risk parity product to market, they did not coin the term. Instead the term, risk parity was first used by Edward Qian, of PanAgora Asset Management, when he authored a white paper in 2005. The term was later co-opted by the asset management industry and evolved into a portfolio investment category. In time, other firms such as AQR Capital
AQR Capital
AQR Capital Management is a hedge fund founded in 1998 by former Goldman Sachs trader, Clifford S. Asness.-Description and history:The firm invests in public equity and hedges markets across the globe...
, Aquila Capital
Aquila Capital
Aquila Capital is the alternative asset management division of the Aquila Group, an independent company that specializes in asset management and investment services for institutional and private investors globally. With investment products like the AC Risk Parity Funds or the Aquila®...
(2004), Northwater, Wellington
Wellington
Wellington is the capital city and third most populous urban area of New Zealand, although it is likely to have surpassed Christchurch due to the exodus following the Canterbury Earthquake. It is at the southwestern tip of the North Island, between Cook Strait and the Rimutaka Range...
, Invesco, First Quadrant, Putnam Investments
Putnam Investments
Putnam Investments is a privately owned investment management firm founded in 1937 by George Putnam, who established one of the first balanced mutual funds, The George Putnam Fund of Boston...
, ATP
Arbejdsmarkedets Tillægspension
Arbejdsmarkedets Tillægspension is a supplementary pension in Denmark, and is Denmark's largest lifelong pension plan. Citizens of Denmark become eligible for ATP payments as soon as they turn 65 years old. Arbejdsmarkedets Tillægspension was amended into law on March 7, 1964.-See...
(2006), PanAgora Asset Management (2006), AllianceBernstein
AllianceBernstein
AllianceBernstein LP is a US-based, global asset management firm, owned by the French insurance conglomerate, AXA, with approximately $402 billion in assets under management, as of September 30, 2011....
(2010) and the Clifton Group (2011) began establishing risk parity funds.
Reception
With the bullish stock market of the 1990s, equity-heavy investing approaches outperformed risk parity in the near term. However after the March 2000 crashDot-com bubble
The dot-com bubble was a speculative bubble covering roughly 1995–2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more...
, there was an increased interest in risk parity, first among institutional investors in the United States and then in Europe. USA investors include the Wisconsin State Investment Board which has invested hundreds of millions in the risk parity funds of AQR and Bridgewater Associates. The financial crisis of 2007-2010 was also hard on equity-heavy and Yale Model portfolios, but risk parity funds fared reasonably well.
According to a 2011 article in Investments & Pensions Europe, the risk parity approach has "moderate risks" which include: communicating its value to boards of directors; unforeseen events like the 2008 market decline; market timing risks associated with implementation; the use of leverage and derivatives and basis risks associated with derivatives. Other critics warn that the use of leverage and relying heavily on fixed income assets may create its own risk. Portfolio manager, Ben Inker has criticized risk parity for being a benchmarking approach that gives too much relative weight to bonds when compared to other alternative portfolio approaches. However, proponents of risk parity say that its purpose is to avoid predicting future returns. Inker also says that risk parity requires too much leverage to produce the same expected returns as conventional alternatives. Proponents answer that the reduced risk from additional diversification more than offsets the additional leverage risk and that leverage through publicly-traded futures and prime brokerage financing of assets also means a high percentage of cash in the portfolio to cover losses and margin calls. Additionally Inker says that bonds have negative skew
Skewness
In probability theory and statistics, skewness is a measure of the asymmetry of the probability distribution of a real-valued random variable. The skewness value can be positive or negative, or even undefined...
, (small probability of large losses and large probability of small gains) which makes them a dangerous investment to leverage. Proponents have countered by saying that their approach calls for reduced exposure to bonds as volatility increases and provides less skew than conventional portfolios.
Risk parity advocates assert that the unlevered risk parity portfolio, is quite close to the tangency portfolio, as close as can be measured given uncertainties and noise in the data. Theoretical and empirical arguments are made in support of this contention. One specific set of assumptions that puts the risk parity portfolio on the efficient frontier
Efficient Frontier
The efficient frontier is a concept in Modern portfolio theory introduced by Harry Markowitz and others. A combination of assets, i.e. a portfolio, is referred to as "efficient" if it has the best possible expected level of return for its level of risk...
is that the individual asset classes are uncorrelated and have identical Sharpe ratio
Sharpe ratio
The Sharpe ratio or Sharpe index or Sharpe measure or reward-to-variability ratio is a measure of the excess return per unit of deviation in an investment asset or a trading strategy, typically referred to as risk , named after William Forsyth Sharpe...
s. Risk parity critics rarely contest the claim that the risk parity portfolio is near the tangency portfolio but they say that the leveraged investment line is less steep and that the levered risk parity portfolio has slight or no advantage over 60% stocks / 40% bonds, and carries the disadvantage of greater explicit leverage.
Despite criticisms from skeptics, the risk parity approach has fared well in the marketplace and has seen a "flurry of activity" in recent years. During the period 2005 to 2009 several company's began offering risk parity products including: Barclays Global Investors, First Quadrant, Mellon Capital Management and State Street Global Advisors
State Street Global Advisors
State Street Global Advisors is the investment management division of State Street Corporation and the world’s second largest asset manager, with $1.9 trillion in assets under management as of June 2010....
. A 2011 survey of institutional investors and consultants suggests that over 50% of America-based benefit pension and endowments and foundations are currently using, or considering, risk parity products for their investment portfolios. Companies like AQR Capital and Bridgewater Associates have attracted clients such as the Wisconsin State Investment Board, The Pennsylvania Public Schools Employees’ Retirement System and the Alaska Permanent Fund Corp to their risk parity funds.