QFIP-144-19: Risk Parity Is All About Balance

Question 1

Shortcomings of traditional approach to asset allocation in light of Risk Parity

Answer 1

The traditional approach to asset allocation tolerates higher short-term risk through a concentration of risk in equities in order to generate higher returns

• This is the traditional Markowitz optimization approach of solving for the weights in different stocks/asset classes in order to maximize the Sharpe ratio of a portfolio
• This approach’s main flaw is it can often result in a heavy concentration in a single type of asset, which brings significant risk of poor long-term returns
• The traditional approach depends on correlation and volatility assumptions of the different asset classes that are unstable and difficult to predict
  
  • ​In reality, though, correlation assumptions between asset classes are just a byproduct of the relationships between the assets and economic drivers

Question 2

Two principles of asset pricing that risk parity is based on

Answer 2

1. Asset classes outperform cash over time
   
   • Reflects the risk premium an investment needs to compensate for the risk that is taken
2. Asset prices reflect the discounted value of cashflows that depend on future economic scenarios
   
   • These expected cashflows (and discount rate) incorporate expectations about the future environment, such as inflation, earnings growth, etc

Key point: The goal of strategic asset allocation in risk parity is to collect the risk premium from asset pricing, while minimizing the risk due to unexpected changes in the economic environment

Question 3

Describe why risk parity works for the All Weather Fund example provided in the reading

Answer 3

Under an economic scenario, the underperformance of an asset class relative to its risk premium can be offset by the outperformance of another asset class with an opposing sensitivity to that risk

• For example, nominal Treasury bonds perform poorly when inflation is higher than expected
• However, commodities perform well when inflation is high
• The impacts on nominal bonds and commodities from high inflation would cancel each other out, leaving the risk premium from these asset classes as the dominant source of returns
• Key Result: More stable portfolio return

Question 4

Performance of Risk Parity vs Traditional Global Equities Portfolio

Answer 4

A risk parity portfolio can outperform a traditional portfolio

• The reading chart shows that the risk parity portfolio can achieve the same level of return with much less risk
• By scaling the leverage of the risk parity portfolio up with cash, one can also show that for the same level of risk, the risk parity portfolio can deliver a higher return