A presentation by Samuel Kunz, chief investment officer of the Policeman’s Annuity and Benefit Fund, Chicago, to the CFA Institute 2011 Asset and Risk Allocation conference addressed the pros and cons of “risk parity.” His presentation makes it seem that risk-parity portfolios (RPP) and the Capital Asset Pricing Model (CAPM) are sibling rivals. They look a bit alike, they have common origins, but they are at odds.
Risk parity is an asset diversification approach that relies less upon equity than certain other “traditional” approaches do. It is more conservative in its choice of assets, but it is more aggressive on the matter of leverage, than those other approaches.
A traditional portfolio allocation might consist of 60 percent equities and 40 percent fixed- income instruments. Equity is the more risky of the two asset classes, and it clearly dominates the risk of the portfolio as a whole in such a case. Parity equalizes the distribution of assets by their contribution to over-all risk. By itself, this change would reduce the return on an RPP vis-à-vis the traditional portfolio. But the RPP is then goosed by higher leverage (often achieved through the use of futures) in order to achieve the same return that the traditional portfolio would.
The arithmetic of an RPP is easy if one begins with the assumption that the risks of the different assets in the portfolio are uncorrelated. It gets more complicated when one takes into account the fact that they often are correlated – that housing markets in Connecticut are likely to rise and fall at much the same time as housing markets in Massachusetts, for example, and may not be entirely independent even of housing in Nevada. Still, the difficulties of the arithmetic can be overcome, and the big benefit of RPP will remain, de-emphasizing equity allows it to get the investors the same rate of return a traditional portfolio would get them while decoupling their fortunes from the booms and busts of the business cycle.
The idea of RPP, and that of CAPM, may both be traced to a paper by James Tobin, “Liquidity Preference as Behavior Toward Risk,” 1958. Tobin argued, as Kunz summarizes it, “that in the presence of a risk-free asset, risk-averse investors should hold portfolios of only two assets: the risk-free asset and a fund of risky assets.”
This is often seen as a precursor to the development of the capital asset pricing model (CAPM), created when William Sharpe cross-fertilized Tobin’s ideas with those of Harry Markowitz. Kunz believes that although the views of today’s risk-parity advocates are consistent with Tobin’s, they are “not so much” in agreement with Sharpe. Indeed, in the absence of “heroic assumptions” one has to infer that the RPP will be leveraging a portfolio that is off of the efficiency frontier, the line representing the best possible trade-offs of risk and return at every point in logical space, according to CAPM.
Another theoretical argument about RPP is that in principle it ignores returns. It ignores any information beyond what is embedded in the historical volatilities (risk) and correlations among those risks that determine the driving idea of parity. The notion that no information about expected returns can be of any value “might be a stretch for some investors,” Kunz says.
Some proponents of risk parity also argue that they can benefit from the leverage aversion of other market participants. Kunz doesn’t endorse this theory, but he paraphrases it. Many investors are restricted either by their own choice or by regulations in regard to how much leverage they can adopt. Such investors end up avoiding the low-risk assets that cannot be worthwhile in the absence of leverage, and that builds a “leverage aversion premium” into the returns on those low-risk assets.
Kunz is dubious about the existence of such a premium because he reasons that in an efficient market it would have been arbitraged away.
There is also the issue of how a risk-parity investor leverages up. There are different approaches, each of which has its own benefits and drawbacks, but Kunz says that the most common approach involves the use of futures.
His own conclusion, after totaling up pros and cons, is, “Risk parity is a good step in the right direction, but I do not think it is a finished product.”