While Report Knocks Risk Parity, Vendors Defend Approach as a Philosophy

(October 13, 2011) — A new research paper by Marlena Lee, vice president at Dimensional Fund Advisors, claims that over the last 81 years, risk parity portfolios have not produced higher Sharpe ratios than the traditional 60/40 balanced approach.

The report, titled “Eight Decades of Risk Parity,” asserts: “This paper uses over a century of returns from nineteen countries to conduct an out-of-sample test of whether risk parity delivers superior risk-return tradeoffs. The results show that previously documented risk parity benefits are sample specific. Over the last eighty-one years, risk parity portfolios do not have higher Sharpe ratios than 60/40 balanced portfolios.”

According to Marlena, while proponents of risk parity claim the investment strategy is an alternative approach to asset allocation that promises better risk adjusted returns than traditional 60/40 balanced portfolios, the “promise is deceptive.” The reason, according to the paper: “Out-of-sample results show that the touted benefits of risk parity only appear in the last thirty years during a period of falling inflation and interest rates. Because bonds did unexpectedly well over this period risk parity portfolios also benefit due to their heavy bond allocations. Unsurprisingly, risk parity does poorly from 1956 to 1980, a period of rising inflation. From 1930 to 1955, a period of volatile but non-trending inflation, risk parity yields Sharpe ratios that are similar to traditional 60/40 portfolios.”

However, while Marlena voices a critical view of risk parity, PanAgora Asset Management views the investment strategy as more of a philosophy for all market environments. “There’s a misperception out there that because risk parity leverages bonds, its success solely depends upon the performance of fixed-income. Our general philosophy of the strategy involves paying more attention to risk evenly — basing our focus on risk rather than allocation of capital,” Bryan Belton, PanAgora’s Director of Multi-Asset Strategies, tells aiCIO.  

“I’m sure the methodology is sound — but as one changes or expands the timeframe for research, the results can be quite different,” Belton says in response to Marlena’s research, adding that risk parity should be viewed as an investment philosophy that adapts to changing market conditions. “Our perspective with risk party is to balance risk – over time, we strive for equal contribution from growth oriented assets, low risk assets – like fixed income, and real assets – like commodities — the idea being that you really don’t know where the market’s headed,” says Belton. “We start with a balanced starting point and make tactical shifts based on the market environment.”

While Dimensional Fund Advisors’ Marlena urges investors to view the benefits of risk parity with skepticism, PanAgora’s Belton asserts that risk parity exemplifies the benefits of diversification — the underpinnings of any investment strategy. “We think anything other than risk parity contains risk concentration, and over the long run risk concentration is not rewarded,” Belton notes.

The assertions by Dimensional Fund Advisors and PanAgora follow recent critical viewpoints voiced by Damon Krytzer, a trustee at the San Jose Police and Fire Retirement Plan and managing director of Waverly Advisors. Dynamic asset allocation and risk parity strategies are often based on incorrect assumptions, according to Krytzer, who notes that while he likes the idea that funds are using risk contribution as the focus rather than return distribution, their investment strategies should be based on different metrics. “These strategies assume that the asset allocation mix doesn’t change over time — with the false assumption based on diversification among asset classes rather than risk factors,” he told aiCIO, noting that focusing on risk factors as opposed to asset classes is a more appropriate emphasis.

He added: “The revised approach would be better because you’re basing decisionmaking on actual underlying drivers that move asset classes — as opposed to asset classes that may be more highly correlated in different markets.”

Despite such critiques, aiCIO Magazine’s first independent survey of asset owners on risk parity investment strategies demonstrates that more than half of respondents (51%) currently allocate to risk parity products or are looking to invest assets in this risk-weighted space. The momentum of such investment also trends clearly to one side: Of those currently with assets dedicated to risk parity strategies, none plans to reduce these holdings, and 45% plan on increasing their allocation in the coming 12 months.