Risk Parity: Past its Prime
Stocks, bonds and other asset classes generally move through long periods of high total return followed by long-periods of low total return. While there is more contention about where we are in the long-term stock cycle, there can be little debate about whether we are closer to the end or the beginning of the long-term interest rate cycle.
The chart below from Mebane Faber's great new(ish) series on Risk Parity demonstrates the long-term efficacy of a static version of the approach for a portfolio of stocks and bonds using long-term relative stock and bond volatility for allocations, and targeting the same long-term volatility as the 60/40 portfolio (10.44%). Notice that to achieve the same level of risk as a 60/40 portfolio, the risk parity portfolio must be levered by 160%.
Chart 1. Long-term risk parity with S&P 500 and 10-Year Treasuries, 1972 - 2012
Source: Mabane Faber, 2012
While the performance of the static risk parity approach is better over the full period, Faber points out that the relative out-performance is sensitive to the start and end dates of the observation period. If we go back in time to mid 2000 and observe the relative performance over the first 28 years, we may have drawn a different conclusion.
Chart 2. Long-term risk parity with S&P 500 and 10-Year Treasuries, 1972 - 2000
Source: Mabane Faber, 2012
So what happened during the last decade to create such a massive disparity in returns? The next chart offers a clue: it plots the progression of interest rates since 2000.
Chart 3. 10-Year Treasury yield, 2000 - 2012
Source: FRED database
Clearly this has been an exceptional period for interest rates, as they have dropped by over 70% over the past 12 years, delivering almost 7.6% in total returns per year, compared with 0.80% per year for stocks.
The question is, with interest rates at or very near historic lows, and the relative return differential between risk parity and more traditional approaches at an all-time high, should we expect this approach to continue to dominate other approaches going forward? Or should we acknowledge that he best days for risk parity are probably behind us, and adapt?
Adaptive Asset Allocation
In this article we will apply the integrated AAA approach described in our whitepaper to create a resilient balanced portfolio that is not vulnerable to the interest rate bias that represents the Achilles Heel of risk parity.
AAA uses estimates of returns, volatility and correlation for assets in a portfolio based on recently observed measures of these parameters, rather than long-term averages. These estimates are then integrated using a robust mean-variance optimization algorithm analogous to the equations described under the banner of Modern Portfolio Theory.
Estimates for returns and correlations are drawn from time series for each asset over a 6-month look-back horizon, while volatility is measured over a shorter 60 day horizon. Further, portfolio level volatility at each rebalance period is managed to a 10% target. Depending on the measured volatility of the assets, and the correlation between them, at each rebalance period, cash or leverage may be required to reach the volatility target. No yield on cash or cost of leverage is included for this illustration.
Chart 4. Adaptive Asset Allocation balanced portfolio, rebalanced monthly, 1995 - May 31, 2012
Max 200% exposure
Many IPSs have, or should have, policy flexibility built into the wording of the statement to allow deviations over periods of up to 3 months from policy benchmarks without official notice, and longer deviations after documented consultation with clients. As a result, the AAA framework is an attractive and viable alternative for traditional balanced clients.
Further, by allowing the portfolio to take on a limited amount of leverage at times of low asset level volatility and/or very low asset correlations in order to achieve the target risk budget, the ARP portfolio delivered a 27% improvement in absolute returns with the same level of portfolio volatility as the traditional balanced portfolio.