March 2012

INSIDE VIEW: Softening the risk potential

ScalesRisk parity is a new asset allocation concept to provide an alternative to the dismal returns achieved over the past few years via traditional balanced portfolios. Magne Orgland explains.

Over the past few years, financial markets have been something of a roller coaster ride, going up and down and around before returning to almost the place they started. As a consequence, more and more investors are looking for an alternative to the disappointing returns generated by traditional balanced portfolios. One promising venue is a new asset allocation concept which is based on risk parity.

What is risk parity? It is a technique of portfolio construction in which each holding provides an equal contribution to the overall portfolio risk, thereby softening the potential loss impact from individual asset classes or instruments. With equal contribution to risk, no asset class dominates the portfolio in terms of risk.

The concept is based on allocating risk instead of capital. Equal contribution to risk is achieved by reducing the exposure to riskier asset classes,  such as equities and commodities, and increasing the exposure to less risky asset classes, such as government bonds or money market investments. In a portfolio of four asset classes, optimal diversification is achieved when each asset class contributes 25% to the risk of the total portfolio. This implies that the riskier asset classes receive lower allocations in terms of capital.

By contrast, in the 1980s, investors constructed their balanced portfolios from a simple mix of large cap equities and government bonds. These portfolios generally had a bias towards the home market. During the next decade, investors took diversification one step further by adding new asset classes, such as commodities, private equity, hedge funds and real estate. The improved diversification came not only from these new asset classes, but also from increasing the global reach of the portfolio, an approach pioneered by the Yale University endowment fund and later followed by other US endowments. These newly-created portfolios seemed to promise improved, risk-adjusted returns.

A traditional balanced portfolio, invested across a variety of equity, bond and, possibly, alternative asset classes, was long considered broadly diversified. Yet, from a risk perspective, the portfolio risk is dominated by the higher risk components, with 90% of the risk frequently originating from the equity allocation. Hence a traditional diversified portfolio often behaves more like a symmetric bet. If equities go up, the investor wins, and if equities go down, the investor loses.

The financial crisis of 2007/08 was a painful reminder of this, with significant drawdowns in portfolios causing major funding headaches for investors like pension schemes.

The traditional “efficient frontier” portfolio involves allocating capital, which in turn drives the risk of the portfolio. Risk parity turns that concept on its head with risk driving capital allocation. The objective is to gain true diversification of risk across the portfolio. The consequence of this approach is that when risk parity is achieved, low volatility, low returning assets dominate the portfolio in terms of capital allocation. This may lead to expected growth that is below the minimum acceptable return.

The challenge then becomes how to adjust the newly created risk-optimised portfolio to fit with the return targets of the investor. The return gap can be filled by introducing leverage to the risk weighted portfolio. Invariably, during portfolio construction, this involves levering up lower volatility assets and, similarly, levering down higher risk assets such as equities.

By introducing leverage to an equal risk portfolio, investors can build portfolios that meet the return expectations associated with higher risk asset classes, but at significantly reduced volatility. In contrast, traditional portfolios seeking higher returns tend to increase the allocation to higher risk assets such as equities and in doing so accept higher overall portfolio risk and lower risk-adjusted returns.

One of the main benefits of an equal risk portfolio is that the likelihood of a severe drawdown from the riskier elements is greatly diminished.

The risks of asset classes themselves also change over time. To maintain an equal risk portfolio, this means periodically adjusting downwards the allocation to asset classes that are becoming more volatile. Similarly, investors can increase the weights of higher beta asset classes during quiet market environments. In this manner, the portfolio is always optimally diversified in terms of risk.

Leverage is typically introduced to the equal risk portfolio by using futures contracts. One of the biggest benefits of futures is that they are very liquid and have extremely low transaction costs. In addition, they offer an implicit leverage.

An investor only need pay a fraction of the nominal value of the contract, whereas, if an investor bought the physical asset, he would need to pay the full price. This enables a risk-optimised portfolio to rebalance risk on a daily basis, at low cost, by scaling up and down holdings in the various assets in order to keep risk at a constant level.

Tail risk
While the risk parity approach may reduce the risks investors face, it does not eliminate risk from the portfolio entirely. There will be environments when low-volatility assets face difficulty, and having leveraged exposure at that time may further exacerbate the downside for that segment of the portfolio. When the risks of asset classes themselves change, they can do so quite dramatically in a tail risk event.

While the risk parity approach ensures the portfolio remains on a smooth and stable keel in 90% of market conditions, the concept can be taken one step further by constantly monitoring various risk factors that can help identify the build-up of tail risk. For instance, during highly volatile times such as the ones seen in the past twelve months, when a gathering tail-risk cloud emerges, allocation to those positions exposed to tail risk can then be reduced or even eliminated. It should also be remembered that tail risk conditions can change very rapidly and tail risk management must take this into account.

In most market conditions, tail risk monitoring will have little impact. But in more turbulent times, it can make a considerable difference. We estimate that for end investors, applying tail risk management can reduce drawdowns by up to 50% in extreme environments as opposed to not having done so.

Of course, asset allocation methodologies continue to evolve. For many years, the cornerstone of asset allocation was diversifying across different asset classes according to capital. Risk parity overturns that concept, with risk allocation now driving capital allocation.

Pension funds are long-term investors and able to absorb market turbulence more than most. However, they too are becoming more interested in how they can better manage their way through periods of extreme price volatility.

Ultimately, risk parity offers a new way to engineer better risk/return trade-offs, manage downside risk and gives investors the opportunity to take advantage of traditional asset classes in a non-traditional way.

By reducing the risk concentration on any single asset class, both the level and the consistency of returns improve, while the risk of drawdown is significantly reduced.

Magne Orgland is head of 1741 Asset Management

©2012 funds europe