Is Risk Parity the End for Asset Classes?

Optimizing a risk-balanced portfolio means abandoning asset classes completely, according to JP Morgan’s latest take on the strategy. 

(October 17, 2012) – Traditional risk parity simply does not go far enough, two top JP Morgan strategists have concluded. 

Investors allocating based on risk rather than asset type and return forecasts still have one foot stuck in the asset class bucket—and it’s dragging them down, Yazann Romahi and Katherine Santiago argue in their new white paper. Both are senior members of the quantitative portfolio strategies team within JP Morgan’s global institutional management division. 

Romahi and Santiago’s paper attempts to answer a pressing question in asset management circles: Can risk parity maintain its stature in an environment of rising rates and increasing correlations among asset classes? 

Yes, they conclude, but not without an overhaul. 

“Replacing the traditional asset class building blocks of risk parity portfolios with a broader spectrum of low correlation risk factors can result in a more robust risk parity solution—one that can be effective across market cycles and despite rising asset class correlations,” the authors concluded. 

These risk factors—credit premium, duration, credit spread, FX momentum, or convertible bond arbitrage, for example—split assets into uncorrelated groups better than asset classes do, the authors contend. Thus, they continue, risk factor categories afford a risk-balanced portfolio more diversification than the traditional approach, while avoiding concentrations into a certain duration or asset class. 

The JP Morgan strategists are not proposing small tweaks and refinements to the prevailing strategy. Their brand of ‘factor risk parity’ deviates from a number of risk parity’s hallmark characteristics. 

As Bob Prince, the co-chief investment officer of Bridgewater Associates, the firm often credited with originating risk parity through its All-Weather fund, defined it to aiCIO, “Risk parity is the mix of assets an investor would want to hold absent a view of markets.” 

In contrast, ‘factor risk parity’ explicitly takes the market into account, during both the allocation process and day-to-day portfolio management. “For some investors,” the authors acknowledge, “a full leap from asset class diversification to factor diversification may be too difficult due to limitations on leverage or an inability to exploit the short side, given that key elements of factor-based asset allocation require more active rebalancing, the use of derivatives and short positions.” 

To Romahi and Santiago, optimizing a portfolio means capitalizing on the equity market’s structural inefficiencies. Researchers have identified small cap and value stocks’ persistent outperformance of large cap equities over the last 85 years (size and value premia), or the low-volatility premia. Likewise, studies have indicated that stocks outperforming the market will continue do so (momentum premia). Taking advantage of these inefficiencies, however, is where shorting comes in. As with extensive derivative use and leveraging, shorting would be departure for many institutional funds. (And for others, an outright violation). 

For many asset owners, even traditional risk parity is problematic on these counts. Tim Walsh, for instance, head of New Jersey’s $70.1 billion state pension system, recently told aiCIO that he’s done his homework on the strategy and decided against it. “Risk parity? At this point, for a fund of our size, it’s just too much leverage.”