A paper by Xiaowei Kang and Daniel Ung, published in June 2014, remains timely because risk parity and related approaches remain the center of controversy and some confusion.
The Kang & Ung paper looked at three approaches to risk factor based portfolio construction, studying specifically the practical aspects of the matter rather than what the authors saw as the overly theoretical view taken by the “numerous research papers that explore this topic.”
The three approaches at issue are: use of risk parity on the asset class level; the combination of beta exposure from individual asset classes with systematic factors such as value; and the more direct approach to the creation of risk premia portfolios, the use of long/short positions to target systematic factors.
Risk Parity Strategy
The global financial crisis clarified the significance of the old adage that “diversification is the only free lunch in investing.” It was not sufficient, heading into that crisis, for an institution’s portfolio to be distributed among statically defined asset classes, “balanced” in the traditional sense. One got the free lunch of diversification only if one was diversified by risk, conscious in particular that equities are much more volatile than fixed income, and thus that they tend to dominate overall risk.
In a sense then the global crisis was an advertising billboard for the risk parity approach.
Still, Kang and Ung say that there are “practical challenges associated with its implementation.” For example, there is a misalignment between asset classes and risk factors, so that some who think they are allocating by risk are in fact allocating by a poor proxy for risk. Second, with interest rates on the floor, so that they have only one direction in which they can move, the prospects that they will move up, whatever the velocity of the move may be, and the predictable consequences of such a move for a bond-heavy strategy, are daunting for those considering the adoption of this approach.
Such considerations will lead many to look at the second approach mentioned above, what one may call the portfolio “building blocks” approach.
The boundary between alpha and beta has become blurry over time. One way of understanding this blurring is to acknowledge a new range of strategies, called “alternative beta” or “smart beta” that are intermediate between classical alpha and classical beta. Another way of looking at it: investors are unhappy with the performance of, and the fees charged by their alpha seeking active managers and are looking for ways to remain active, while economizing.
The authors create a hypothetical alternate beta equity portfolio that enhanced return by about 3.2% per year and reduced volatility by about 2.6% per year over the 18 years preceding their work. Also, their equally hypothetical alt beta commodity portfolio produced a more significant return/volatility improvement than that.
Investing in Risk Premia Directly
The third approach considered involves the direct investment in risk premia. To test this view, the authors constructed a hypothetical portfolio consisting of 10 liquid risk premia. They took long positions on the small cap, low vol, value, momentum, and quality indexes, and in each case took a short position on the benchmark. In commodities they took long positions on curve, value, and momentum through long-short commodity indexes. For fixed income, they took a long position on U.S. corporate high yield bonds and a short position on T-bills.
The retrospective results here were in a sense disappointing. Yes, this approach yielded substantial returns. But the portfolios involved possessed remarkably high volatility and maximum drawdowns.
On the plus side, though, correlations among risk premia are historically low, with an average pairwise correlation of “almost zero.” This starkly contrasts with correlation among asset classes. Thus, the authors found it unsurprising that ”some institutional investors have already started making allocations to risk premia strategies as a low-cost alternative to absolute return strategies.”
Here too there are important implementation issues. For example, although the strategies require short selling, “it may become prohibitive or even impossible to short securities in times of crisis.” Also, it can be tricky to devise an appropriate weighting scheme.
In their conclusion, Kang and Ung observe that no tools in prospect “eliminate the need for active management.” There is no remote control portfolio that will eliminate the human factor in combining the various building blocks and maneuvering around implementation difficulties.