No, I don’t mean tactically. I like to think I’m bold, sometimes a bit too bold, but not crazy! We think both stocks and bonds are both quite expensive versus history and that this typically, though not always, leads to lower than normal long-term returns. But valuation is a poor timing method. We are not writing articles, belying my title, about how risk parity or for that matter traditional 60/40 investing is tactically attractive now. The risk parity versus 60/40 argument has always been about strategic long?term — not tactical short?term — asset allocation (tactical arguments are fine, they just are not the point here; if you can time the stock and bond markets, you could do so whether using a traditional or risk parity type strategic allocation as a baseline). Here I argue that, when viewed strategically, the empirical work on risk parity, including some of our own, understates its potential advantages. Moreover, all you need is basic finance theory to see it; and, as we'll see, you have to have rather pessimistic assumptions about risk parity to not add any of it to an existing 60/40 portfolio.
There has been a lot of dispute about the historically achievable Sharpe ratio of risk parity versus 60/40. Issues abound. What period is a fair one to judge the key assets (stocks, bonds, commodities, inflation protected bonds, etc.)? How much should we subtract from a backtest to account for costs, both trading and leverage? We have taken, to nobody’s shock, a pro-risk parity position. To see some of the back and forth, check out articles here, here, here, and here. In fact, we have written a new rejoinder, which will come out soon in the Financial Analysts Journal (here’s a preview of our comments: the paper we’re responding to flat-out mistakes a difference in volatility due to risk targeting for transactions costs and the cost of leverage).
One thing these challenges and defenses generally have in common is that they focus on the direct comparison of a portfolio like traditional 60/40 to risk parity. They ask, which has the better Sharpe ratio after considering all real life implementation issues? This is the right way to compare if one is considering between two alternatives: 1) staying completely traditional, in this case 100% invested in regular old 60/40, or 2) moving 100% to risk parity. But this is trying to answer a question few are asking; very few will actually consider a 100% move to risk parity. Rather, investors interested in risk parity are mostly interested in making only a partial allocation to it. And, if one is considering a partial allocation, comparing Sharpe ratios, as both we and the risk parity critics have done too often, is not the right approach at all.
Think about how you decide to allocate a small part of your portfolio to something new. Do you say, “Does this have a larger net Sharpe ratio than my entire portfolio?” No, you don’t. Whether examined formally through assumptions and quantitative analysis, or informally, the proper question is: “Does this allocation make my total portfolio better?” In that case, the assumed Sharpe ratio of the new investment is, of course, important, but so is its correlation to your existing portfolio. If the correlation is low enough, an allocation to an investment with a modest Sharpe ratio offers improvement over your starting portfolio.
[drizzle]To formalize this a bit, let 60/40 represent the traditional portfolio and RP represent the risk parity portfolio. If you had to choose between 100%/0% and 0%/100% it would come down to, after all costs, whether:
If that were satisfied, a 100% allocation to risk parity would be superior to a 100% allocation to 60/40.
But, if you were willing to consider less extreme allocations, anywhere between 0% and 100% to risk parity, the question is different, it’s whether or not ?RP > 0 in the simple regression:
That is, if 60/40 is your starting portfolio, you’ll want to allocate some amount away from it to risk parity if your best guess of ?RP is positive. That’s basic portfolio math. In English, it says that if risk parity is not perfectly correlated to 60/40, and 60/40 is your entire portfolio, the hurdle to allocate some money to risk parity is whether it adds value net of any common variation with your starting 60/40 portfolio, not whether risk parity completely dominates 60/40 head-to?head (in a comparison of 100% in risk parity to 100% in 60/40).
I think we sometimes forget this Finance 101 idea when thinking about risk parity, often implicitly arguing about whether an investor should be all 60/40 or all risk parity. That’s just wrong! We don’t seem to make this mistake for most other investments. We don’t require them to be better than our entire current portfolio — and then, if so, assume we move into them 100% leaving our current portfolio entirely. But for some reason, perhaps because the topic itself is strategic allocation, we seem to evaluate risk parity this way. But there’s really no reason why it should be thought of differently. If a partial allocation makes your portfolio better, a partial allocation should be made.
Let’s consider a simple example. We often use a “simple” risk parity strategy in backtests. It does not include everything we use in real implementations today — neither all the assets nor all the portfolio management and risk control. For one thing, we desire a long backtest, and many of the assets that we think worthwhile to include today don’t have a long-enough history (e.g., inflation-protected bonds in the U.S.). For another, we want to keep it as free from data mining as possible.
Over 1947-2015 we find the gross Sharpe ratio of 60/40 to be 0.52 and of this simple risk parity backtest to be 0.75. We also find that both — 60/40 by outcome and risk parity by design — deliver long-term volatility of just about 10%. That means risk parity outperforms 60/40 by almost 2.5% a year (almost but not quite the Sharpe difference times a 10% volatility — in backtests, the volatilities come out close to but not exactly 10%). It also means that you could take off up to this amount per annum in costs and haircuts of all kinds (trading, leverage, a belief that future risk-adjusted returns will strongly favor equities) and still prefer risk parity to 60/40 if those two extremes were the only choices. But is 2.5% actually about the right hurdle?
Let’s return to our regression based approach and estimate equation (2) empirically using the 1947-2015 monthly returns (all numbers annualized):
This says first that for every 1% move in 60/40, risk parity tends to move 70 bps. This makes sense, as 60/40 is dominated by equities and risk parity has fewer equities and more of everything else.
Of course the 4.0% figure is our focus. The roughly 2.5% return difference we found earlier was the amount by which we could reduce risk parity returns and still prefer it to 60/40 in a