9 September 2012

Turning academic insight into investment performance™

Applied Quantitative Strategy www.empiritrage.com

Risk Parity
Summary
 We analyze 3 papers in the “risk parity” series:
Wesley R. Gray, PhD
[email protected]  “Leverage Aversion and Risk Parity” by Asness, Frazinni, and Pederson (2012)
+1.773.230.4727  “Risk Parity Portfolio vs. Other Asset Allocation Heuristic Portfolios” by Chaves,
Hsu, Li, and Shakernia (2011)
Yang Xu
[email protected]  “On the Properties of Equally-Weighted Risk Contributions Portfolios” by
+1.484.340.9126 Maillard, Roncalli, and Teiletche (2010)
 Our primary focus is on “Leverage Aversion and Risk Parity” (2012) by Asness,
Carl Kanner Frazzini, and Pederson, which offers the most practical and straight forward analysis of
[email protected] risk parity.
+1.216.650.3832
 The following quote from Asness, Frazzini, and Pederson quickly summarizes the idea
Cliff Gray behind risk parity.
[email protected]  “Risk Parity investing starts from the observation that traditional asset allocations,
+1.650.804.5712 such as the market portfolio or the 60/40 portfolio in U.S. stocks/bonds, are
insufficiently diversified when viewed from the perspective of how each
investment contributes to the risk of the overall portfolio. Because stocks are so
much more volatile than bonds, movement in the stock market dominates the risk
in a 60/40 portfolio. Thus, when viewed from a risk perspective, 60/40 is mainly
an equity portfolio since nearly all of the variation in the performance is
explained by variation in equity markets. In this sense, 60/40 offers little
diversification even though 60/40 looks well balanced when viewed from the
perspective of dollars invested in each asset class.”
--“Leverage Aversion and Risk Parity” by Asness, Frazinni, and Pederson (2012)

 We end this report by highlighting research that is critical of the risk parity approach.

 Our conclusion on risk parity as an asset allocation system is mixed. On one hand, the
back-test results are solid. However, one must use significant amounts of leverage, it is
unclear what the benchmark is when assessing risk parity portfolios, and there are open
questions as to whether slight perturbations in estimation techniques affect results. In a
future research report we will address these research questions—as well as others--in
detail.

PLEASE SEE THE DISLAIMER AND DISCLOSURES AT THE END OF THIS REPORT. The information set forth herein has been obtained or
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implied, as to the information’s accuracy or completeness, nor does Empiritrage recommend that the attached information serve as the basis of any
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further review and revision.

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Abstract

We show that leverage aversion changes the predictions of modern portfolio theory: It causes safer assets to offer higher
risk-adjusted returns than riskier assets. Consuming the high risk-adjusted returns offered by safer assets requires
leverage, creating an opportunity for investors with the ability and willingness to borrow. A Risk Parity (RP) portfolio
exploits this in a simple way, namely by equalizing the risk allocation across asset classes, thus overweighting safer
assets relative to their weight in the market portfolio. Consistent with our theory of leverage aversion, we find empirically
that RP has outperformed the market over the last century by a statistically and economically significant amount, and
provide further evidence across and within countries and asset classes.
________________________________________________________________________________________________
Source: Leverage Aversion and Risk Parity (2012), Financial Analysts Journal, 68(1), 47-59.

Constructing Risk Parity Portfolios:

The risk parity portfolio (RP) is rebalanced at the end of every month. To construct the RP, we estimate the volatility 𝜎�𝑖 ,
of all the available asset classes (using data up to month t-1) and set the portfolio weight in asset class 𝑖 to:

−1
𝑤𝑡,𝑖 = 𝑘𝑡 𝜎�𝑡,𝑖 𝑖 = 1, … , 𝑛
We estimate 𝜎�𝑡,𝑖 as the 3-year rolling volatility of monthly excess returns, but get similar results for other volatility
measures. The number 𝑘𝑡 is the same for all assets and controls the amount of leverage of the RP portfolio. The first
portfolio is an unlevered RP, obtained by setting
−1
𝑘𝑡 = 1�� 𝜎�𝑡,𝑖
𝑖
This corresponds to a simple value-weighted portfolio that over-weights less volatile assets and under-weights more
volatile assets. The second portfolio is a levered RP obtained by keeping 𝑘𝑡 constant over time:

𝑘𝑡 = 𝑘
For comparison purposed, we set k so that the annualized volatility of this portfolio matches the ex-post realized volatility
of the benchmark (VW market or 60-40 portfolio). This portfolio corresponds to a portfolio targeting a constant volatility
in each asset class, levered up to match the volatility of the benchmark.

Here is a quick example to explain the weighting. Let’s say that we have 3 assets A, B, and C which each have
volatilities 5%, 10%, and 20% respectively (this corresponds to 𝜎� above). Then

𝑘𝑡 = 1� 1�5 + 1�10 + 1�20 = 20�7

20 4 20 2 20 1
𝑤𝐴 = �5 = , 𝑤𝐵 = �10 = , 𝑤𝐶 = �20 =
7 7 7 7 7 7

Note how this over-weights the less volatile assets and under-weights more volatile assets. Using a volatility of 10%
(The value-weighted market portfolio (stocks, bonds, credit, and GSCI from 1973-2010) in this paper is 10.10%), we
would get the following weights:

1
𝑤𝐴 = 10⁄5 = 2, 𝑤𝐵 = 10⁄10 = 1, 𝑤𝐶 = 10⁄20 =
2

Now our weights add up to more than 1, and we use leverage to match the volatility of the value-weighted market
portfolio. We can in a similar manner change the volatility to match any other underlying portfolio, such as the 60/40
portfolio or the stock market. Please note this does not include covariance, which you may want to account for when
computing the weights.

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Comparing the risk-return relationship for the risk parity, 60/40, and the market portfolio
• For the levered risk parity portfolio, the weights are multiplied by a constant to match the ex-post realized volatility
of the value-weighted benchmark

Comparing the Sharpe ratios for the levered risk parity, 60/40, and the market portfolio
• For the levered risk parity portfolio, the weights are multiplied by a constant to match the ex-post realized
volatility of the value-weighted benchmark

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Summary Statistics and Weights

Global Evidence

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Other Risk Parity Papers

 “Risk Parity Portfolio vs. Other Asset Allocation Heuristic Portfolios” by Chaves, Hsu, Li, and Shakernia (2011)

Summary
1. Compares returns between the risk parity portfolios and other asset allocation strategies, such as equal weighting,
minimum-variance, mean–variance optimization, and the classic 60/40 equity/bond portfolio.
2. Over the last 30 years, the Sharpe ratios for the risk parity and equal-weighted portfolios have been much more
stable than other weighting schemes.
3. Risk parity provides better diversification in terms of risk allocation compared to the equal-weighted portfolio.
4. Last and most importantly, show that risk parity performance can be highly dependent on the investment universe.
Further research is necessary to evaluate which asset classes to include in risk parity

Subsample Analysis (Sharpe Ratios)

Sensitivity to different asset classes being included

5 Asset Classes:
• BarCap U.S Long Treasury Index, BarCap U.S. Investment Grade Corporate Bond Index, S&P 500 Index, Dow Jones
UBS Commodity Index, and FTSE NAREIT US Real Estate Index.
9 Asset Classes:
• BarCap U.S Long Treasury Index, BarCap U.S. Investment Grade Corporate Bond Index, JP Morgan Global Gov’t
Bond Index, BarCap U.S. High Yield Corporate Bond Index, S&P 500 Index, MSCI EAFE Index, MSCI Emerging
Market Index, Dow Jones UBS Commodity Index, and FTSE NAREIT US Real Estate Index.
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Other Risk Parity Papers

 “On the properties of equally-weighted risk contributions portfolios” by Maillard, Roncalli, and Teiletche (2010)

Summary
1. Compares the returns and the marginal risk contributions between the equal-weight (EW) portfolio, the minimum
variance (MV) portfolio, and the risk parity (RP or ERC – Equal Risk Contribution in the paper) portfolio. By
construction, the volatility of the RP will be above the MV, and hopefully below the EW.
2. For the global diversified portfolio, risk parity (ERC in table) has the following:
• Higher Sharpe ratios than MV and EW
• Lower volatility and drawdowns than the EW portfolio
• More diversification of assets (see 𝐻𝑤 𝑎𝑎𝑎 𝐺𝑤 which correspond to the Herfindal and Gini indices which
measure concentration)
• Less risk contributions (see 𝐻𝑟𝑟 𝑎𝑎𝑎 𝐺𝑟𝑟 which are Herfindal and Gini indices of the risk contribution)
• Lower turnover than the MV portfolio (see 𝑇𝑤 )
3. Note that in this paper, no leverage is used to make each portfolio have the same volatility.
4. Last, the paper performs a similar analysis on US stock sectors and US commodities, and finds the RP volatility and
Sharpe ratios being greater than the EW portfolio, but lower than the MV portfolio. This is different from the results
for the global diversified portfolio, which has the Sharpe ratio for RP higher than MV.

Comparison of the 3 portfolios (EW, MV, RP) for the global diversified portfolio from 1/1/1995 – 12/31/2008.

13 Asset Classes:
• S&P 500 (SPX), Russell 2000 (RTY), DJ Euro Stoxx 50 (EUR), FTSE 100 (GBP), Topix (JPY), MSCI Latin America
(MSCI-LA), MSCI Emerging Markets Europe (MSCI-EME), MSCI AC Asia ex Japan (ASIA), JP Morgan Global
Govt Bond Euro (EUR-BND), JP Morgan Govt Bond US (USD-BND), ML US High Yield Master II (USD-HY), JP
• Morgan EMBI Diversied (EM-BND), S&P GSCI (GSCI).

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Critiques of Risk Parity Papers

 “The Hidden Risks of Risk Parity Portfolios” by Ben Inker (2010)

Summary of problems with risk parity:

1. Leverage is a dangerous tool for investors; although it can magnify returns, a levered investor may not be able to
wait for prices to converge toward economic reality. One example is an asset-backed bond that a levered investor
would have been required to liquidate in 2008, even though these bond continued to pay interest and principal.
2. There are several asset classes that usually have negative risk premiums associated with them, and leverage does not
help these returns. From 1941-1981 T-bills and T-notes had negative real returns for investors. Two other examples
are commodities since 2001 and government bonds (currently in the author’s opinion).
3. Negative skew (fact the negative returns tend to be larger in magnitude than positive returns) can be especially
hurtful when combined with leverage.

 “Risk Parity – Rewards, Risks and Research Opportunities” by Barry Schachter and S. Ramu Thiagarjan (2011)

Summary of risk parity problems:

1. There is some subjectivity in evaluating the correct assets classes to overweight. In a low growth and low inflation
regime, gold and nominal bonds may outperform whereas equities and commodities do better in high inflation and
high growth regimes. Identifying the correct econometric model to determine future inflation and growth is
subjective but necessary to maximize returns.
2. Agrees with Inker’s assessment of asset classes having negative risk premia, such as commodities and bonds.
3. There has been research done (Garlappi and Uppal 2009) that has shown the estimation errors in the mean-variance
strategy are such that the loss from sub-optimal diversification is more than offset by the elimination of estimation
error under the 1/n strategy (simple EW portfolio). Thus further research needs to be done to show that the tradeoff
between risk parity estimation error and sub-optimality (of EW portfolio) is superior.
4. Trading costs need to be accounted for, since you need to rebalance at the end of each month, and this can be high
since you may be using leverage for certain asset classes.
5. You need to focus on defining risk (which is more comprehensive than volatility), not expected returns. Risk in a
levered portfolio has many facets – kurtosis (fat tails), illiquidity, counter-party, contagion, and many others.

Counter-points and Suggestions

 “Counter-Point to Risk Parity Critiques” by Ed Peters (2010)

1. While critics point out that from 1941-1981 the 10 year US treasuries had “negative real return” and claim that using
leverage would have been bad, it is important to remember that you would have leveraged the nominal return, thus
the total return, which equals leveraged nominal return – inflation, would have been positive. Also, the negative real
return occurred because of two events of hyper-inflation (post WWII and 1979-1981). Now there are hedging tools
(TIPS and commodities) to hedge against this inflation risk.
2. Two suggestions that are given in the paper:
• Not all assets should be leveraged. Any asset that already has internal leverage (such as stocks and corporate
bonds) should not be leveraged. Thus the only asset that should be leveraged would be sovereign bonds, since
these can be easily leveraged in the futures market where there is no counter-party risks or liquidity issues in
times of crisis.
• Commodities are not expected to produce a positive excess return in the long run, they should be used to
hedge a portfolio against inflation. Thus a full risk parity allocation to commodities is not desirable.

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DISCLAIMER

The views expressed are the views of the authors and are subject to change at any time based on market and other
conditions. This document shall not constitute an offer to sell or the solicitation of any offer to buy any security and
should not be construed as such. References to specific securities and issuers are for illustrative purposes only and not
intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. While all the
information prepared for this document is believed to be accurate, Empiritrage, LLC makes no express warranty as to the
completeness or accuracy, nor can it accept responsibility for errors appearing in the document.

DISCLOSURES

Performance figures contained herein are unaudited and prepared by Empiritrage, LLC. They are intended for illustrative
purposes only. Past performance is not indicative of future results, which may vary.

There is a risk of substantial loss associated with trading commodities, futures, options and other financial instruments.
Before trading, investors should carefully consider their financial position and risk tolerance to determine if the proposed
trading style is appropriate. Investors should realize that when trading futures, commodities and/or granting/writing
options one could lose the full balance of their account. It is also possible to lose more than the initial deposit when
trading futures and/or granting/writing options. All funds committed to such a trading strategy should be purely risk
capital.

Hypothetical performance results (e.g., quantitative backtests) have many inherent limitations, some of which, but not all,
are described herein. No representation is being made that any fund or account will or is likely to achieve profits or losses
similar to those shown herein. In fact, there are frequently sharp differences between hypothetical performance results
and the actual results subsequently realized by any particular trading program. One of the limitations of hypothetical
performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does
not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in
actual trading. For example, the ability to withstand losses or adhere to a particular trading program in spite of trading
losses are material points which can adversely affect actual trading results. The hypothetical performance results
contained herein represent the application of the quantitative models as currently in effect on the date first written above
and there can be no assurance that the models will remain the same in the future or that an application of the current
models in the future will produce similar results because the relevant market and economic conditions that prevailed
during the hypothetical performance period will not necessarily recur. There are numerous other factors related to the
markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the
preparation of hypothetical performance results, all of which can adversely affect actual trading results. Hypothetical
performance results are presented for illustrative purposes only.

There is no guarantee, express or implied, that long-term return and/or volatility targets will be achieved. Realized returns
and/or volatility may come in higher or lower than expected.

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