(April 9, 2014) — Allocating even 30% of one’s portfolio to risk parity strategies could improve the Sharpe ratio by nearly 20%, according to a paper by BlackRock.
The report, written by Vincent de Martel and Daniel Ransenberg of BlackRock’s multi-asset strategies team, found that “there is a sweet spot for risk parity allocations,” for even the most exploratory of investors.
“This is helpful for plans sponsors sensitive to peer comparisons—they can be forward-thinking without going too far out on the cutting edge,” the authors said.
BlackRock’s data revealed that as portfolios move along a continuum from a traditional asset allocation to an entirely risk parity portfolio, the Sharpe ratio rose by more than 40%. The traditional portfolio, the report said, is defined as an average asset allocation of large pension funds with the Sharpe ratio of 0.35.
“But regardless of the size of the position, portfolios show improvement in risk-adjusted performance when risk parity strategies are added to the mix,” the authors said. “[Risk parity] is not a single strategy, but an overall approach to asset management. It could ultimately represent the entirety of an investor’s asset allocation.”
Sharpe ratio increases are not the only reason to implement risk parity, according to BlackRock.
“Risk parity is a bridge between the hedge fund world and the traditional index world,” the report said.
For corporate plans, investors could benefit from risk parity’s equity-like qualities in expected returns, but also take advantage of its ability to reduce pension plan assets and balance sheet volatility. Corporate plans with liability-driven investment-focused strategies could typically fit risk parity into a growth portfolio and pair it with liability-matching assets, the paper said.
Public pensions, on the other hand, could consider risk parity with target returns and liquidity. The investment staff could also use risk parity to develop a risk-based investing framework and policy with stakeholders.
“The key to this versatility has been risk parity’s consistency in returns versus equities, and the resulting ability to deliver compound returns over long historical periods,” the authors noted. “Risk parity may deliver equity-like returns over the long term without having to endure equities’ roller-coaster highs and lows even in a rising rate environment.”
BlackRock’s data found that on the surface, equities outperformed risk parity by an average of 2.4% each year from 2007 to 2013. But when calculated cumulatively, the returns were “nearly identical over this period.”
“Risk parity strategies vary in implementation and continue to be refined, but they share a basic premise and objective: building a portfolio based on diversifying sources of return, in pursuit of strong, consistent returns and avoidance of drawdowns in recessions and periods of economic stress,” the report said.
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