Risk parity gained popularity during the crash of 2008, but interest gradually declined over the following years when the stock market only rose. Diversification has become cool again since the start of the pandemic as a mitigant in an uncertain and unstable world. But these funds have not always managed to perform as advertised, leaving investors, especially non-professionals, with unexpected losses.
While risk parity has been interpreted in various ways, the working definition for asset managers today is a fund that tries to take equal volatility between stocks, bonds and commodities, with overall volatility target which is most often 10% per year. This is approximately the volatility of a classic portfolio invested 60% in stocks and 40% in bonds. But because equities are more volatile than bonds, 60/40 has taken 82% of its equity risk over the past 10 years and therefore gained only limited diversification benefit from bonds and none from commodities. . In theory, and based on empirical evidence going back decades, risk parity should deliver consistently better returns with the same volatility as 60/40.
However, over the past 10 years, taking excessive risk on stocks has been a winning move. Equities averaged 10.9% pa, bonds -0.9% and commodities -0.4%.(1) As a result, the risk parity index did not reported as 6.0% with a realized volatility of 10.8%, compared to 6.3% with a volatility of 10.1% for a 60/40 Portfolio.(2)
But as Cliff Asness, chief investment officer of AQR Capital Management LLC (who I spent a decade working for) points out, that’s not the way to look at it for most investors. If you had to choose between putting all your money in a risk parity fund versus 60% in stocks and 40% in bonds, you would choose the higher return and lower volatility. But most investors think of adding risk parity to an existing portfolio. Risk parity has an “alpha” relative to 60/40, which means that a combination of risk parity and 60/40 does better than 60/40 alone. If you put 20% in risk parity and 80% in 60/40, you’ve had an annual return of 6.3% over the past 10 years, with volatility of 9.8% — essentially the same return as 60 /40 with a little less volatility.
While these statistics are not inspiring, remember that they were made during the longest equity bull market in history, when bonds and commodities lost money. Few investors have the confidence that will characterize the next 10 years. Given that risk parity was only slightly below 60/40 on an absolute basis, and added value when combined with 60/40, in the worst possible market, there is reason to think it might be a good addition to stock/bond portfolios in the future.
Stocks are down 16.5% with 19.8% volatility over the past year, and bonds are down even more, 19.8% with 6.3% volatility. Thus, 60/40 was crushed, losing 17.5% with a volatility of 13.5%. In this disastrous year, risk parity didn’t work well – two-thirds of its risk was in underperforming assets – but it was helped by a record 22.9% return for commodities. (although with an exorbitant volatility of 20.2%). Net income was a down year, minus 11.3% with volatility of 14.3%, but a strong performance compared to 60/40. Over the past year, an 80% 60/40 portfolio with a risk parity of 20% added 1.2% to annual returns and reduced volatility by 0.5% compared to a pure 60/40 portfolio .
Unfortunately, while risk parity works in theory and has a respectable track record over the past decade, the risk parity funds made available to the public have not lived up to the theory. The table below shows statistics for some public funds over the past year (the UPAR Ultra Risk Parity ETF only has 36 weeks of data and AQR has renamed its risk parity fund, although it still follows the principles of risk parity while having added active management).
Why do most public funds lag so far behind the index? Two reasons. First, the S&P Risk Parity Index ended up taking 5.0% volatility on stocks, 6.2% on commodities and 6.5% on bonds. Of course, it tries to achieve equal volatility across all three asset classes, but it’s impossible to perfectly predict future volatility. The RPAR allocation was 4.1%/2.4%/5.3%, a significant underweight in commodities. PanAgora did better, 6.0%/4.5%/5.2%, but still underweight commodities. UPAR was unbalanced with 9.2%/3.6%/7.5%. Wealthfront actually had short equity volatility, with -1.1%/3.0%/4.0%. Only the AQR was close to parity with 3.9%/4.6%/4.7%.
The second reason was performance relative to a constant allocation. The S&P Risk Parity Index beat a constant allocation to the three asset classes by 9.0%. This outperformance stems from the modification of allocations during the year to maintain constant volatility, which contributed significantly to performance. Basically, volatility rose in asset classes before prices fell and fell before prices rose.
The RPAR lost 2.9% due to the constant allocation, which in addition to the change in allocation is caused by the fees (the S&P index and the component indices are displayed without fees) and also by the selection of portfolios stocks, commodities and bonds that differ from indices. PanAgora lost 5.5% at constant allocation, UPAR lost 4.7% and Wealthfront lost 13.0%. Only the AQR fund wins, 5.9%.
This is not a year calculated to bring investors back to risk parity. Most risk parity funds in the market have provided dismal returns and even the best fund and the index have lost money. Quants will continue to sing the praises of diversification and alpha, but until retail risk parity managers can get closer to theory and we get a period of actual positive returns, I think risk parity will remain an institutional strategy.
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(1) For equities, this is the S&P Eurozone, US and Japan LargeMidCap index. All indices are in US dollars and represent total returns. For bonds, this is the S&P Global Developed Aggregate Ex-Collateralized Bond Index. For commodities, this is the Dow Jones Commodity Index.
(2) This is the S&P Risk Parity Index – 10% Target Volatility.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Aaron Brown is a former Managing Director and Head of Capital Markets Research at AQR Capital Management. He is the author of “The Poker Face of Wall Street”. He may have an interest in the areas he writes about.
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