Managing Downside Risk with Tail Risk Parity

Managing Downside Risk with Tail Risk ParityRisk parity is an asset-allocation strategy that determines investment weightings by the amount of “risk” they contribute to the portfolio. Risk parity defines “risk” as volatility, and aims to equalize risk from each asset class across the portfolio. As a result, the strategy allocates portfolio risk away from riskier assets, such as equities, and into less risky assets such as bonds. The result is often greater downside protection versus a traditionally allocated portfolio and dampened gains when risk assets are performing well.

In contrast, tail risk parity (“TRP”) seeks to protect against losses from extreme “tail” events, while providing more upside exposure than risk parity. While risk parity is based on volatility, TRP is based on “expected tail loss” – or AB Global’s proprietary “ETL.” This is the subject of AB Global’s new white paper: An Introduction to Tail Risk: Balancing Risk to Achieve Downside Protection.

Tail Risk Parity (TRP) adapts the risk-balancing techniques of Risk Parity in an attempt to protect the portfolio at times of economic crisis and reduce the cost of the protection in the absence of a crisis.

In the paper, authors Ashwin Alankar, Michael DePalma, and Noble Laureate Myron Scholes make the case for TRP as a “desirable portfolio construction methodology.” They begin by demonstrating the difference between tail risk and volatility, and then move on to provide empirical evidence for TRP as a cost-effective means of portfolio insurance. Finally, they conclude by outlining the three properties that make TRP superior to the alternatives.

Expected Tail Risk vs. Volatility

In using AB Global’s proprietary ETL measure, tail risk parity provides downside protection while maintaining more upside participation than risk parity. That’s because ETL is a “measure distilled from options-market information” designed to estimate the probability of severe downturns, while risk parity relies on volatility, a generic measure of price movement either down or up.

Tail Risk Parity vs. Options

TRP adapts risk parity’s risk-balancing techniques to protect portfolios in times of severe economic crises and to reduce the cost of protection in the event there is no crisis. Typically, investors purchase portfolio protection in the options market, but AB Global estimates the historical savings of the TRP technique at as much as 50% compared to the use of options.

Tail Risk Parity vs. Risk Parity

TRP aims to provide portfolios with the most downside protection when investors need it most – this is when the marginal utility of each dollar is highest, the authors point out. But this means that, during times when ETL is low, TRP portfolios will purchase less downside protection, and as a result, they may end up closely resembling risk parity portfolios.

Tail Risk Parity Properties

The authors of AB Global’s paper conclude their work by listing three properties of TRP that, in their view, make it a “desirable portfolio construction methodology.” They are:

  • A focus on losses, rather than volatility
  • Less-concentrated tail risk
  • Resiliency in spikes of correlation, which typically involve economic crises

With turmoil hitting global markets in mid-to-late August, the publication of AB Global’s new white paper is well-timed.

For more information, download a pdf copy of the white paper.

Past performance does not necessarily predict future results.

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