According to AQR’s Cliff Asness, anyone who thinks risk parity caused the massive selloff in August has gone “all tinfoil-hat.” A better argument against risk parity, Mr. Asness concedes, is the fact that it has underperformed over the past several years.
But is this underperformance a result of the strategy having jumped the proverbial shark? Or is it simply a bad run to be expected with any strategy?
Not surprisingly, Mr. Asness thinks it’s probably the latter, and this is the view he articulates in “Putting Parity Performance into Perspective,” the alliterative latest in his Cliff’s Perspectives series of white papers.
Risk Parity Basics
Mr. Asness takes the first few paragraphs of the paper to refresh readers on the basics of risk parity: “an alternative long-term strategic asset allocation” used to “diversify a more traditional equity-dominated allocation.” Rather than weighting holdings by market cap, risk parity weights them based on their anticipated contribution to overall portfolio risk – and in order to achieve the right mix, this means leverage is used to ramp up low-risk fixed-income holdings.
From Cliff’s perspective, risk parity offers a “real but modest long-term edge” over traditional approaches because many investors are “too averse” to applying leverage. Risk parity is often described as an “all-weather” solution, succeeding regardless of the broad market’s ups and downs, and Mr. Asness believes this is true – on average. Unfortunately, we’re not living in “average” times, and as a result, risk parity has underperformed since 2009.
It’s impossible to do true risk parity back-testing as far back as 1947, so AQR uses “Simple Risk Parity” for historical analysis. The firm’s findings indicate that the “real but modest long-term edge” that risk parity enjoys over indexing really adds up over time. This is evident in the image below, which charts the cumulative excess return of Simple Risk Parity over the past 68 years:
The image above shows Simple Risk Parity’s excess returns above cash. The image below shows its excess return above a “60/40” stock/bond portfolio. This helps put the strategy’s underperformance since 2009 into longer-term historical perspective:
Risk parity is designed to diversify away from equity risk. Instead of adding equities to a portfolio in pursuit of desired returns, risk-parity strategies favor using leverage to ramp up fixed-income risk. With equities outperforming for the past six years, it should be no surprise that risk parity has underperformed. Moreover, risk parity strategies have also been slammed by the bear market in commodities, whereas “60/40” portfolios don’t even have direct exposure to that asset class.
But do these facts mean that risk parity’s happy days are over? Not in Cliff Asness’s view. He suggests that the recent underperformance is of the sort that’s to be expected with long-term strategies, and adds that periods of underperformance are often followed by periods of outperformance.
The problem, as he sees it, is that short-term periods of poor performance can feel awfully long – and this can lead to investors bailing at the wrong time. If traders have tactical reasons for wanting to allocate away from risk parity, that’s one thing – but selling because of painful results that should be expected from time to time is unwise, in Asness’s view, even if resisting the urge to do so is “one of the hardest but most important parts” of an investment professional’s job.
For more information, download a pdf copy of the white paper.