I’ve written before about the somewhat unhinged attacks on risk parity for having caused the market’s August sell-off. Frankly, if the goal were to attack risk parity, the critics made a silly choice to go all tin-foil-hat instead of just doing what people usually do — attacking recent performance. They’d have to attack relative performance (versus, say, the most common benchmark of 60/40 U.S. equities/bonds) because absolute performance hasn’t been as big of an issue. But that shouldn’t slow down a dedicated critic. So, this note addresses what earthbound critics would normally be saying, and more generally examines what undeniably has been a tough relative performance period for risk parity (while being a pretty good period for many of our systematic strategies, like quantitative stock selection and broad-based style investing, during a period generally regarded as difficult for alternative investing in particular).

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Let’s first review a few basics about risk parity:

  • It’s an alternative long-term strategic asset allocation that’s typically used to diversify a more traditional equity-dominated allocation.
  • We think it offers a real but modest long-term edge over traditional approaches. We believe this occurs mostly because many investors are too averse to applying leverage, even to a modest degree, to the “best” portfolio as basic theory would suggest. Rather, investors who need to take a fair amount of risk tend to concentrate it in the riskiest assets, mostly equities. This leads to investors generally undervaluing diversifying assets that improve risk adjusted returns (but perhaps not total returns without some leverage) and overvaluing assets that provide aggressive returns without financial leverage.[1]
  • Better diversification and a modestly higher Sharpe ratio does not always win! Risk parity is often described as better diversified across economic environments, succeeding in rain or sleet or shine. We believe these statements are true on average but, of course, not all the time, and taken alone tend to overstate the case. In particular, regardless of environment, when equities, the asset class that dominates traditional portfolios, outperform other asset classes by a lot, risk parity will very likely lose to them and asset allocations dominated by them (if equities outperform by less, the edge risk parity gains from superior diversification may still be able to make up the difference). Furthermore, again, risk parity’s edge is important but modest. A modest edge adds up over the long-term but should not be oversold.

Back to recent performance. For several years now, we have used the long-term returns on something we call “Simple Risk Parity” to conduct our investigations. Actual implemented risk parity, at our or any firm, can’t be fully tested over very long periods because returns of many assets within a risk parity portfolio today (e.g., stocks and bonds of many countries, certain commodities, inflation-linked bonds in the U.S.) aren’t available for the length of time we wish to analyze. We describe our approach to Simple Risk Parity in other places but, essentially, it is equal-risk-weighted (using a relatively simple model of conditional risk) across the best proxies we have historically for global stocks, bonds and commodities. Despite some design differences, the total return on this simple backtest has been highly correlated to the live performance of our real-life risk-parity portfolios. Furthermore, the total live returns we’ve experienced (since we launched it in 2006) have been comparable to this backtest over this same period (this despite the Simple Risk Parity backtest being gross of trading costs).[2] Basically, while not perfect, we think it’s a pretty reasonable proxy for how real-life risk parity behaves, and one that we can examine back to 1947.

So let’s examine absolute performance (the performance of risk parity itself, not risk parity versus anything else, save cash). The graph below shows the summed monthly cumulative excess return (risk parity excess over cash) from the start in 1947 through November of 2015:

AQR Perspective 12 01 15 fig 1 RIsk Parity
RIsk Parity

[drizzle]Source: AQR; the simulated Simple Risk Parity strategy is based on a hypothetical portfolio described in greater detail at the conclusion of this document. Please read important disclosures at the conclusion of this document.
Nothing too weird or unpleasant seems to be going on lately.[3] In fact, the graph is good for some perspective. Risk parity had an unpleasant drop back in the spring of 2013 that made media headlines. Can you see it in the graph? You can but you have to squint. Risk parity certainly fell in the global financial crisis (we think it’s a better strategic allocation but it’s still long markets) and that’s clearly visible, but it doesn’t look that bad does it? Drawdowns in real life always seem to feel longer and induce more pain than you’d imagine when looking back. This is true for risk parity and all of investing, and is a big part of why investing is harder than it looks!

But, remember, the knock on risk parity lately (not the tin-foil-hat knock about causing market drops!) is about relative performance versus 60/40, not about absolute performance. In this, the critics are not mistaken. We certainly do see some real recent pain. Below I graph the cumulative difference in return between Simple Risk Parity and U.S. 60/40:

AQR Perspective 12 01 15 fig 2 RIsk Parity
RIsk Parity
Source: AQR; the simulated Simple Risk Parity strategy is based on a hypothetical portfolio described in greater detail at the conclusion of this document. The U.S. 60/40 portfolio consists of a 60% allocation to the S&P 500 index and a 40% allocation to U.S. 10-year Treasuries, rebalanced monthly. Please read important disclosures at the conclusion of this document.
The source of the long-term positive performance (that is, why the line generally moves up!) is better diversification, in particular making assets like bonds and commodities count as much, but not more than, equities. The source of the recent pain is largely three-fold:

  1. Risk parity is a diversification away from equity dominance. That’s the whole idea. Risk parity’s relative performance peaked back when the stock market cratered in 2009, and has since suffered due to the long and strong equity bull market.
  2. More recently, returns have suffered from the very sharp downturn in commodities, which are not in the 60/40 portfolio at all.
  3. Since 2009, U.S. stock market performance has been superior to the global equity portfolio implemented by risk-parity approaches.

We can all debate how predictable the above three were and whether a deft timer could’ve avoided or profited from them. In addition to offering steady strategic allocations to risk parity, we ourselves offer risk parity portfolios that are more tactical, that tilt a bit away from risk parity, in any direction, as our signals dictate. But that debate, while very interesting and important, is a non-starter for us when it comes to the basic idea of risk parity. To us, as we’ve always emphasized, basic risk parity is a different strategic allocation. Investors can still choose to be as active as they want on all decisions — including the three implied above (making forecasts for equities vs. other asset classes, commodities, or the U.S. versus other countries) — whether they believe the proper starting point is,

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