risk parity

Risk premium parity or risk parity is an academic idea that has made its way into institutional investment management, particularly among hedge funds.

The main idea, which has many variations, is this:

Let’s say an investor has his portfolio allocated 50% to bonds and 50% to stocks.  If we use the academic definition of risk as volatility, we observe that maybe 75% of the risk in the portfolio is represented by the stocks in it.

We can reduce the risk of the portfolio, and thereby provide protection against loss, by shifting the asset allocation away from stocks and toward bonds.  Let’s do so until the riskiness of the two components is equal.  That would be at 2/3 bonds and 1/3 stocks.  At this point, both portfolio elements are in risk premium parity.

If we do so by selling bonds to buy stocks, we’re reducing the profit potential of the portfolio.  Let’s not do this.  Instead, let’s borrow and buy more bonds to increase that weighting.  If the original portfolio was $50 in stocks and $50 in bonds, the new result is $50 in stocks, $100 in bonds and ($50) in margin debt.

This reconfigured portfolio should have lower volatility than the original, but superior return potential from the positive spread between the coupon earned on the bonds bought on margin and the cost of the margin debt.

a viable strategy?

Theoretically, yes.  In practice over an extended period of time, yes.

Worries?

Yes!!

There are three about risk parity:

1.  We’ve been in a thirty-year bull market in bonds, as the Fed aggressively attacked incipient runaway inflation in the early 1980s and has been lowering rates since then.  Is the success of risk parity a result of superior portfolio design or simply having a huge leveraged cocktail of bonds in the mix?  …or is the academic endorsement of risk parity simply a distraction from the fact that the outperformance comes from the large size of the bond holdings?  Put another way, is the risk parity bond strategy a disaster waiting to happen in a rising interest rate environment?
2. Lots of institutional money is in the risk parity strategy.  That’s because success breeds imitation.  It’s also because pension funds love portfolio strategies implemented by computers and based on academic theories–which they believe insulates them from reliance on (fallible) human judgment.
3. Other than perhaps on the run Treasuries, bonds aren’t the most liquid of investments.  This illiquidity is in part the reason for bonds’ low volatility, since professionals realize the scope for trading is limited.

What happens, then, if bonds start to perform badly, risk parity managers begin to rebalance toward stocks and institutional clients begin to pull their money out?  No one really knows.  This is not only a worry for holders of risk parity portfolios.  It’s a potential problem for the bond market in general–and by extension for other financial assets as well.