Tomorrow’s Risk Parity Today by Jeffrey Knight, Columbia Threadneedle Investments
Reprinted with permission from CIO October 2015 ©1989-2015 Asset International, Inc. All Rights Reserved. No reproduction or redistribution without prior authorization. The original article can be accessed by clicking here.
Jeff Knight, global head of investment solutions and asset allocation for Columbia Threadneedle Investments, speaks with CIO’s Kip McDaniel about risk parity’s (and the market’s) August horribilis and how, looking forward, CIOs can benefit from an adaptive approach.
CIO: It’s been a challenging market and risk parity strategies have not been immune to the carnage. How do you respond to investors who come to you and say “I thought that risk parity was supposed to do well in every market?”
Knight: The goal of risk parity is to improve the impact of diversification by mixing exposures to diverse asset classes in a way that distributes portfolio sensitivity to each component fairly evenly. If diversification is a good thing, then stronger and more deliberate diversification should be a better thing. Still, there are certainly market environments that can produce negative returns from risk parity. Eliminating drawdowns from a long, risk-taking strategy is not realistic. Through superior diversification, though, risk parity can be expected to produce more efficient return patterns over time. One way to think about this is that the drawdowns experienced by risk parity should be more modest, in comparison to its positive return episodes, than other, less well-diversified strategies.
That said, market outcomes that are unfavorable to risk parity seem to be showing up more regularly lately, in particular, highly correlated asset class performance. While that may not be that surprising on the backend of global quantitative easing and a zero interest-rate cycle, it is a little unfair to blame the “mixing” of portfolio ingredients for disappointing returns when the explanation has much more to do with the ingredients being mixed. Moreover, living in the US and following the local stock market has perhaps obscured the fact that this has been an insidiously difficult market for certain asset classes, like emerging market stocks or commodities which are represented in the typical risk parity strategy.
Imagine a bar chart of returns of the various components of a typical risk parity strategy over the past 12 months, or even over the third quarter of 2015. Two insights would stand out from such a chart. First, the returns for most asset classes have been negative. Since risk parity is a formula for participating evenly in those (risk-adjusted) returns, a negative return is a very straightforward consequence. The second thing that one can observe is that the poorest performers—commodities, emerging-market equity, foreign exchange, real estate, etc.—are down 30%, 40%, or more. The S&P 500 or long-dated treasuries might be at the top of the leader board because they are up a percent or two. With this deep negative skew across building blocks, risk parity naturally produced a negative result. In an episode where the building blocks of the strategy are moving down in a correlated fashion, we can’t eliminate market volatility—I am not sure what would.
CIO: It seems like risk parity has always been an approach that pundits love to hate.
Knight: For a long time we heard from critics who said that this is a bad environment for risk parity because it amplifies the impact of bonds on portfolio outcomes. Now, these critics might be shouting “I told you so!” but this is a little disingenuous. In fact, it hasn’t been the bonds that have hurt. The best Sharpe ratios that we have seen over the last year have been long-dated treasuries. It is very easy to sound the alarm about what you want to own or not own, but it is harder to know this presciently.
Another controversial aspect of risk parity, of course, is that the strategy employs leverage. There exists an aversion to leverage, which is understandable but not perfectly rational at the levels we are talking about. Risk parity managers employ leverage to extract as strong a diversification benefit as possible. It’s not about leveraging any individual asset. Leverage allows you to separate your decisions on how you balance risks from how much risk you want to take overall. Without leverage, your asset allocation latitude is much more limited. If you want to take on more risk, you don’t have many choices in how you can do that, and you end up concentrated in higher volatility assets. With leverage, you have a larger opportunity set. To be able to separate how you diversify risk from how much risk you want to take is a very powerful concept. But the further away you get from those of us who are practitioners to the CIOs, boards, financial advisors, and their customers, the more the folklore and scariness begin to dominate.
CIO: And more recently we have had people say, “It’s so big; it’s wagging the dog.”
Knight: Yes, and concurrently wondering, “If it’s so great why isn’t everybody doing it?” The math blaming risk parity for the market volatility does not really add up. Managers do not calibrate to daily changes in volatility. And there would be asymmetric impact on the upside, and no one said that risk parity drove all of the market gains that we saw earlier.
CIO: You employ an adaptive risk parity approach. Did it perform as predicted?
Knight: Yes. We acknowledge that today’s market environment can be unfriendly to risk parity structures, and we deliberately designed our strategy to attempt to recognize and react to conditions that threaten the “optimality” of risk balance. Since inception, this approach has been helpful overall. There have been a number of months since we launched the strategy last year in which classic risk parity strategies have struggled, and our approach has led us to “defect” from pure risk parity successfully for several, but not all, of these months. The success rate, while not perfect, has been consistent with our expectations.
CIO: Did you learn or change anything after August?
Knight: We always learn from challenging months, but we have not changed anything. Our strategy defaults to a risk-balanced approach unless there is something atypical going on, and then we have rules about alternative policy portfolios for differing market states. None of those were triggered in August, so we were aligned with our normal risk-balanced policy. Now, you can’t predict everything perfectly, so how do you find the right balance between type 1 errors (where you changed something but wished you did not) and type 2 errors (where you stayed put and wished you had moved)? We are always seeking a better answer to that question. August was a type 2 error, I suppose. A better outcome would have been produced if we had mapped to a capital preservation-oriented portfolio. If we had specified our market classification differently, we might have been in a much safer and de-risked position over the last few months. That would have been great, but those revised rules would not have served us well during other episodes when de-risking would have been the wrong thing to do. It was a bad month for risk parity, but not a month that causes us to question the approach entirely. You are going to have bad months.
Beyond August itself, I think that the message of the last year is this: it is becoming increasingly difficult to produce stable portfolio performance relying exclusively upon diversification across traditional asset classes. If you are a CIO with a big allocation to risk parity, I would not say you should be cutting that allocation, but I would say you should be looking to augment the diversification equation with an expanded palette of holdings, like alternatives or high-active risk strategies.
CIO: What do you expect going forward?
Knight: Our research suggests that this is an environment conducive to balancing your risks. You might describe the volatility of the past year as being primarily a deflationary impulse that came to subsume many different things. The biggest quandary to me is why, in the context of a big deflationary shock, did we not see stronger performance from duration? From a valuation perspective, it creates the possibility of a big bond rally. If the deflationary impulse is durable and semi-permanent, then bond yields could come way down and you would make money on that part of your risk parity portfolio.
If it is temporary, then all the assets that have been hurt by the deflationary impulse should rebound somewhat, and that part of your portfolio would come around. This is an environment where risk-balanced asset allocation is very much in tune with pricing and where we are in the economic cycle.
The things that would cause us to consider a different risk-weighting would be if bond yields fell so much that duration risk loses its ability to be a diversifier, or conditions for risk assets improved so much that we would want to overweight them. We are not seeing either of these, and so I still think that a risk-balanced approach is appropriate.
CIO: CIOs may be reading the Financial Times and getting a little worried. Optics aside, is now a better time to be invested in risk parity?
Knight: I think so. As I mentioned, some of the components of risk parity are down 40% or more this year, and now have these greatly improved prospective returns. Why buy the dip in US equities when you have other assets down 40% to 50%? Diversified global approaches like risk parity can get you access to these opportunities in a balanced way. For those inclined to be contrarian, I think risk parity becomes a pretty interesting way to put a toe in the water—a safer way to buy dips in some of the asset classes that have had real downside volatility.
We looked at performance across diverse global balanced strategies since the beginning of last year, and an interesting pattern emerged. Three-quarters of the managers in our study showed negative returns since January 2014. Of those that are positive, that subset includes all of the risk parity funds. In this slightly longer time period, the recent struggles of risk parity disappear.
If there’s one thing to learn from recent events, it is that expectations for classic risk parity are very high—maybe too high. Even as a very sound way to arrange your investment risk, it does not guarantee that you won’t suffer drawdown or that the world will play out in a way that is always flattering to a pure risk parity approach. I continue to think that risk parity offers a superior approach to diversification than traditional strategies, but the future may not be as great as the past. We think that having something else to draw upon other than pure risk balance (i.e., an adaptive approach) is important, helpful, and maybe even necessary as we go through the backend of this policy cycle.