Despite the fact that institutional investors have poured billions of dollars into risk parity strategies over the past decade, UBS Global Research strategists Stephane Deo and Ramin Nakisa don’t have much use for risk parity. Instead, they believe that money managers should construct portfolios using Sharpe parity, which Deo and Nakisa declare “much better than risk parity” in their recent Weight Watcher white paper.
Based upon the testing done by UBS, and related results shown below, its hard to argue with Deo and Nakisa.
What is Risk Parity?
Risk parity seeks to limit risk in a portfolio by reallocating risk more equally in a portfolio across various asset classes, and typically overweights lower volatility assets relative to a traditional portfolio. As a result, risk parity portfolios show a preference for lower volatility assets. This may make sense, but risk parity would judge a low volatility asset class in a downtrend as being “safer” than a more-volatile asset class that is in a consistent uptrend. Authors Deo and Nakisa say that the role of an allocation strategy should be to maximize returns while managing risk – and risk parity doesn’t even consider returns.
What is Sharpe Ratio?
UBS’s Deo and Nakisa favor Sharpe parity over risk parity for portfolio construction, but to understand Sharpe parity, one must first understand the Sharpe ratio, which is a calculation that measures an investment’s “excess returns” (returns above the “risk-free rate of return”) per unit of risk (as measured by standard deviation). Thus, when comparing two investments, the investment with the higher Sharpe ratio has provided more return per unit of risk.
Sharpe Parity Explained
Deo and Nakisa recommend portfolios be constructed using Sharpe parity for management of risk and returns. Assets in a Sharpe parity-weighted portfolio are weighted in proportion to their Sharpe ratios, so that assets with the potential for the greatest risk-adjusted returns are given emphasis. In the words of Neo and Nakisa:
“Think about it this way: if asset X has a Sharpe ratio of 2 it means that we have two units of return for 1 unit of risk, while asset Y with a Sharpe ratio of 1 gives us only 1 unit of return for the same amount of risk. In that case we construct a portfolio with the weight for asset X being double the weight of asset Y.”
Deo and Nakisa point out that volatility is not the only measure of risk. Indeed, many corporate bonds are illiquid and nonvolatile because they trade so sparsely – but this illiquidity carries its own risks that aren’t measured by risk parity. What’s more, the returns on bonds are typically much lower than equities, and yet since risk parity doesn’t even consider potential returns, risk parity-weighting inevitably overweighs fixed-income products – this is particularly troubling given the tough road ahead for bonds in an environment of rising interest rates.
The author’s also note that risk parity doesn’t even consider diversification in its makeup, whereas Sharpe parity-weighting creates a naturally diversified portfolio, since the risk-reward calculation doesn’t favor any asset class. Riskier asset classes are viewed in terms of a risk-reward calculation, whereas risk parity simply favors the least volatile securities, which may or may not have any potential for reward. This difference in diversification leads to a slightly better drawdown and recovery profile of the Sharpe weighted portfolio, as shown below:
Stephane Deo and Ramin Nakisa make a provocative argument against risk parity, which is an investment approach that has gained a lot of traction over the past 5-10 years. Deo and Nakisa pull no punches and offer few if any kind words for risk parity, which they view as being vastly inferior to Sharpe parity. Their challenge to the status quo has earned them critics, but the data in their Weight Watcher white paper give strong support for their case that Sharpe parity is simply “much better than risk parity.”
While Sharpe parity portfolios have yet to hit the market, there are a variety of risk parity mutual funds available to investors and we expect to see a risk parity ETF from State Street fairly soon. Perhaps with the publication of the reseach work by Deo and Nakisa, we will eventually see the introduction of a Sharpe parity based fund.