An article by Morningstar called "Risk Parity's Year to Forget" focuses on the poor performance of all of the managers who embraced the risk parity technique. The managers, from Bridgewater, AQR, Putnam to Investco, all got killed with performance relative to a simple 60/40 stock bond allocation rule. (There we go again with simple 60/40 rule.) They got beat by the tactical allocation category by 500 + basis points in some cases. "All weather" can give you stormy weather when the low risk asset classes like bonds under-perform. Investors have to accept this difference in performance because a risk parity approach does not have a market view other than equal weights will do better in the long-run.
So what is going on with risk parity? The idea of a risk parity model which looks to equally weight risk across even the simplest case of stocks and bonds will hold a big allocation to bonds, the less risky asset. This overall risk can be targeted to a level, but a 50/50 risk allocation between stocks and bonds will result in much more dollar bond exposure. Under a normal 60/40 stock mix, stocks will actually represent close to 90 percent of the risk.
If bonds under-perform stocks, the risk parity approach will significantly under-perform more conventional approaches. My take-away is that an emphasis on risk equality or more precisely budgeting still has to think about the relative performance of assets. This emphasis on performance is all the more important if the approach is non-traditional.
Some would argue that having a view on returns is at odds with the very approach of risk parity. I would disagree once you think in terms of a risk budget and not risk equality. You should have a view that risk should be equalized under a informationless view of the world, but if an investor has a view on returns, it would seem natural to tilt the risk exposures. Hold more risk in the asset that will perform better.
Some of this relative performance is inherent in the classic 60/40 stock bonds mix. If you believe there is a long-term positive equity risk premium over bonds, then holding more stocks would seem to be a natural long-term allocation. If you believe risk premiums across asset classes are different, a risk budget could be an effective allocation scheme, but risk equality may generate periods of modest returns if lower risk (high allocation) asset classes perform poorly.
If bonds under-perform stocks, the risk parity approach will significantly under-perform more conventional approaches. My take-away is that an emphasis on risk equality or more precisely budgeting still has to think about the relative performance of assets. This emphasis on performance is all the more important if the approach is non-traditional.
Some would argue that having a view on returns is at odds with the very approach of risk parity. I would disagree once you think in terms of a risk budget and not risk equality. You should have a view that risk should be equalized under a informationless view of the world, but if an investor has a view on returns, it would seem natural to tilt the risk exposures. Hold more risk in the asset that will perform better.
Some of this relative performance is inherent in the classic 60/40 stock bonds mix. If you believe there is a long-term positive equity risk premium over bonds, then holding more stocks would seem to be a natural long-term allocation. If you believe risk premiums across asset classes are different, a risk budget could be an effective allocation scheme, but risk equality may generate periods of modest returns if lower risk (high allocation) asset classes perform poorly.
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