Update Client Magazine for Institutional

A Risk-Conscious Approach to Investing Using Risk Parity

Update Magazine - IV 2013 - Allianz Global Investors - Risk Parity

Risk parity is an investment approach aimed at spreading risk evenly. In a conventional 50/50 balanced portfolio, the equal balance between equities and bonds only relates to market value. Since equities are generally exposed to greater risk than bonds, they dominate the risk profile – but also the return to a considerable extent. By contrast, the exposure associated with equities is reduced in favour of bonds in a risk parity portfolio, such that each asset class contributes one half to the portfolio risk. The ensuing reduction of overall risk is a side effect of this approach.

Example of the advantages of risk parity
For illustration purposes, a simplified yet nevertheless realistic example where volatility is the risk measure: in this case of a 50/50 balanced portfolio, equities demonstrate 16% volatility and bonds 4%. For simplification purposes, the correlation between the asset classes is assumed to be zero. In this example, the volatility is 8.25%, with equities accounting for more than 94% of the total risk. In reality, therefore, the balanced portfolio is actually highly concentrated and largely dependent on stock market performance.

“The real reason, then, why the risk parity strategy is successful is not the performance contribution but the diversification effect of bonds.”

By contrast, the risk parity portfolio is invested 20% in equities and 80% in bonds. At 4.5%, volatility is much lower, and risks are diversified (Chart 01).

Several alternatives are available to a bond investor who does not want to risk more exposure than that associated with a pure bond portfolio (4% volatility): instead of allocating 100% to bonds, he can either invest 48.5% in the 50/50 balanced portfolio, 88.4% in the risk parity portfolio, or 25% in equities. In each case, the remaining money would be allocated to risk-free – for example money market – investments.

All approaches demonstrate the same risk level of 4% volatility. But what about the earnings side? In order to analyse the earnings side, the long-term expected return for bonds is fixed at 1.5% p.a., and for the money market at 0.1% p.a. These are conservative figures given the current yield curve in Europe and the USA, and the historical excess returns of typical bond portfolios vis-à-vis the money market.

Based on this assumption, the 50/50 balanced portfolio will only demonstrate a higher expected return than the risk parity portfolio if the expected return on equities is more than 10%. This means that the risk premium for equities must be at least 8.5%, which is high by historical comparison. In the event that equities demonstrate an expected return of exactly 10%, the 25% allocation to equities (with the remaining 75% invested on the money market) can be expected to return just 2.58% p.a. In spite of the extremely high risk premium for equities, the expected return for the diversified risk parity portfolio is greater, at 2.84% p.a. As such, even if the outlook for equities is extremely positive, investors should still consider the diversified investment. After all, if the optimistic prospects for equities fail to materialise, a diversified investment offers clear advantages.

For some investors, the 30-year bond rally is the only reason why the risk parity strategy succeeds. In the example above, however, the earnings expectations are much higher for equities than for bonds. Nevertheless, a greater (risk-adjusted) return can be expected with the diversified risk parity allocation than from the best asset class (equities). The real reason why the risk parity strategy is successful is therefore not the performance contribution but the diversification effect of bonds. The potential inherent in this diversification effect is often underestimated. The more (independent) asset classes that are included, the more potential the approach offers.

Allianz Global Investors expands the Risk Parity 1.0 approach
The example above clearly shows that the approach adopted by many investors of focusing strictly on specific asset classes in expectation of considerable additional earnings is not always the best course of action. This is why Allianz Global Investors favours active management, where risk parity forms the anchor portfolio, and active opinions are then built in around this portfolio. Asset classes with positive (negative) prospects are assigned a higher (lower) risk contribution, to enable promising opportunities to be exploited and unattractive risks avoided.

“In light of this, the risk parity approach should be combined with active asset allocation in order to increase returns and reduce risks.”

The market cycle indicator developed by Allianz Global Investors offers an objective, transparent and understandable means of integrating active opinions relating to any asset class into the concept. The indicator is based solely on historical prices, and comprises a trend and trend reversal component. The concept behind the development: capital markets frequently pursue longer-term trends that are measured by the pro-cyclical trend component. However, the markets often tend to exaggerate, which is then mapped by the counter-cyclical trend reversal component. Since the magnitude of the trends differs for each asset class, the value of the market cycle indicator can also differ. This method therefore supports the intelligent management of risk contributions. Greater risks are taken in those markets that promise disproportionately high expected returns. By contrast, risks are actively reduced in markets with negative prospects.

Longer-term advantages of the dynamic risk parity approach
The benefit of a dynamic risk parity approach becomes obvious in a historical comparison: US equities, US treasuries and commodities have all demonstrated largely the same Sharpe ratio1 of about 0.35 between the beginning of 1970 and today. Over the same period, the dynamic risk parity strategy with market cycle indicator and the three asset classes generated a Sharpe ratio of 0.73. Even the best combination of all three asset classes cannot match this result, which therefore clearly demonstrates the advantage of the dynamic risk parity concept compared to a static approach. Even breaking down the entire period by the respectively best asset class, and determining the Sharpe ratio for each equity, government bond or commodity period shows that the strategy earns stable returns in all scenarios, and generates at least the same average Sharpe ratio as the best asset class in each case. As such, investors either need very good forecasting capabilities, or they should prefer the dynamic risk parity approach.

In a global and broad variant, Allianz Global Investors recommends starting with a dynamic risk parity portfolio comprising twelve asset classes (Chart 02). The advantage of this asset class selection is not only that risk parity exists among the twelve classes, but that the parity is also maintained for various clusters. A look at the “risk cluster” shows that risk parity exists between the “risk on” asset classes (equities, commodities, REITs2, and high-yield and emerging market bonds) and the “risk off” classes (all other bonds). The allocation of the three “equities” (including commodities and REITs), “government bonds” (incl. inflation-linked bonds) and “credit” (all other bonds) clusters also demonstrates risk parity. Last but not least, the allocation to the “growth” (equities, and high-yield and emerging market bonds), “inflation” (commodities, REITs and inflation-linked bonds) and “recession” (all other bonds) economic phase clusters also demonstrates risk parity (Chart 02).

“Active asset allocation using the market cycle indicator can even increase average return by about 65 base points p.a. without increasing risk.”

Such a broad portfolio can only be analysed from 2001 onwards. Historical simulation produces a remarkable result: despite including asset classes with below-average performance, even the standard risk parity approach (without active asset allocation) is capable of generating an identical return with the same risk exposure as government bonds, which were the best asset class in the period in question. Active asset allocation using the market cycle indicator can even increase average return by about 65 base points p.a. without increasing risk. Furthermore, the realised annual losses can be limited to about 5%, and the average return increased (Chart 03).

That’s all very well for the past, but what about the future? Compared to all other asset classes, the dynamic risk parity strategy demonstrates a more attractive risk/return profile based on expected returns and risks, which can be derived from current market data using scenario analysis and Monte Carlo simulation. So the success of the dynamic risk parity strategy continues (Chart 04).

[1] The Sharpe ratio measures the excess return of an asset class per risk unit of volatility
[2] REIT: Real Estate Investment Trust = stock exchange-listed property company.