By Samuel Lee
The future delights in humiliating seers. Five years ago, who
predicted that the rich world would reprise the Great Depression?
And yet here we are: The United States government can run annual
deficits amounting to 9.0% of GDP, triple the monetary base to $2.6
trillion in a few years, and still issue 30-year bonds yielding
2.6%. The surprising frequency of the "unthinkable" happening
suggests we are overly confident in our ability to see the future.
The "risk-parity" approach to portfolio construction is a powerful
way to combat this mistake. Pioneered by Bridgewater Associates,
modern risk-parity portfolios adhere to a simple principle: balance
exposures across all the major economic scenarios by volatility.
The hope is that such a portfolio will perform well in all economic
climates--and indeed risk-parity strategies have.
The strategy is gaining influential adherents, mainly among
institutions, but hasn't caught on with individuals. Will this
strategy work in the future? Could an individual investor apply it?
I think the answer is, tentatively, yes to both questions. To
understand why risk-parity works, we have to revisit a common
fundamental misconception of portfolio construction.
The typical investor thinks of assets as being like indivisible
elements, with distinct characteristics. In contrast, the
risk-parity approach begins with the observation that asset classes
can be described in much the same way atoms can be described as
combinations of electrons, protons, and neutrons. The fundamental
particles in the risk-parity view of the world are inflation and
economic growth. This isn't a modern insight, but one that's been
around academia for decades. The risk-parity application is
relatively new, however.
Standard portfolio construction advice does not lead to
risk-balanced portfolios. The typical 60% stock/40% bond
portfolio's volatility is 90% determined by equities, which are
reliant on declining inflation and economic growth. What happens
when inflation ticks up or growth slows? Standard portfolios
The Four Economic Configurations
Economies have four main configurations, characterized by
combinations of rising/falling inflation and rising/falling
economic growth. Changes in inflation and economic growth can
explain the gross behavior of almost any asset class.
Naturally, in each phase of the business cycle, different assets
are king. Stocks do best when the economy is growing and inflation
is falling, coinciding with the recovery phase after a recession;
bonds do best when the economy is tanking and inflation is falling,
coinciding with the downward leg of a conventional recession. These
are sensible relationships--stocks rise in anticipation of
increased earnings growth, and bonds rise when inflation or
interest rates fall. For the most part, it doesn't really matter
what kind of stocks or bonds you own--whether they're growth/value
or corporate/Treasuries--each asset class will largely obey its
relationship to economic growth and inflation.
Unsurprisingly, the equity-risk-dominated 60/40 portfolio does
best during disinflationary booms. Assuming the historical
distribution of economic scenarios is a decent guide to the future,
the 60/40 portfolio is heavily geared to do well about half of the
time. This is tolerable if the bad months are randomly interspersed
with good months. However, history suggests economic scenarios are
clumpy, sometimes lasting decades, lulling investors into only
preparing for the risks that have showed up in recent memory.
Investors failing to hedge their bets against all four economic
scenarios are implicitly betting on their prescience and exposing
themselves to big tail risks. This seems foolhardy, given that in
the past 40 years we've had inflationary recessions (1970s), a
deflationary recession (2008-09), and disinflationary booms (1980s
and 1990s). The practical outcome of risk-parity thinking is to add
more inflation hedges to the conventional 60/40 portfolio, reducing
equities' volatility contribution.
The Original Risk-Parity Strategy
Harry Browne's Permanent Portfolio is probably the most well-known
risk-parity-like strategy. Browne kept it dead simple: 25%
allocations each to gold, long Treasuries, equities, and cash,
roughly balancing one's risk exposures across all four economic
configurations. While it is crude compared to newer
volatility-targeted risk-parity strategies, the Permanent Portfolio
has stood the test of time. Over the period 1973-2012, its Sharpe
ratio, defined as return above cash divided by its standard
deviation, was a respectable 0.48, better than the 60/40
portfolio's 0.40. The Sharpe ratio understates its advantage,
because the strategy had smaller drawdowns, less fat-tail risk, and
the ability to hold up well when you needed it to.
We can improve upon Harry Browne's formulation. It doesn't hold
broad commodities or foreign bonds and stocks. I've created a model
portfolio diversified across all four economic configurations that
goes some way to rectifying the 60/40 portfolio's imbalances. It's
not designed to shoot the lights out, but rather ensures no one
economic environment devastates your wealth. I confess I couldn't
bring myself to advantage a fourth of your portfolio in long
Treasuries, of which the 30-year only yields around 2.6%. Perhaps I
am committing the sin of overconfidence.
(click to enlarge)
Investors expecting the Permanent Portfolio and its variations
to repeat last decades' performance are in for disappointment, I
fear. Browne's strategy is reliant on now richly valued hedge
assets, gold and Treasuries. Investors should expect only
low-single-digit real returns from today's valuations.
Beyond the Permanent Portfolio
Several risk-parity mutual funds attempt to earn higher returns by
applying leverage to balance the volatility contributions of a
variety of asset classes, including commodities, corporate bonds,
and currencies. The theory and expectation is that leverage allows
the funds to be more efficiently diversified without sacrificing
returns; an unleveraged portfolio will have high risk-adjusted
returns but low absolute returns--the problem faced by the
Permanent Portfolio. Why should this theory hold?
In an ideal world, it should not. Even in a less-than-ideal
world, investors would observe the strategy's excess returns and
arbitrage it away. Is the risk-parity cat out of the bag? Maybe
not. If your reaction upon hearing the word "leverage" is alarm,
you are not alone. And this widespread revulsion may keep
risk-parity profitable. Leverage is anathema to many investors,
meaning a sizable class of investors resort to riskier assets to
achieve their expected-return targets. We are observing such a
shift today: investors are shifting from bonds to dividend stocks
to boost their yields, even though classical finance theory says
that they should be borrowing money instead. The result of leverage
aversion is that low-volatility asset classes offer higher
risk-adjusted returns, which can be exploited by investors willing
to use leverage--that is, risk-parity investors.
The biggest true risk-parity funds are Invesco Balanced-Risk
) and AQR Risk Parity(
) . Their institutional share classes charge reasonable but hardly
bargain fees. Don't read too much into their excellent short-term
records, however. These funds' real benefits should materialize
when tail risks show up; until then, don't be surprised by long
bouts of underperformance.
Even if you don't fully trust these newfangled risk-parity
strategies, it's still worthwhile to stress-test your portfolio to
see how sensitive it is to all four economic scenarios.
Note: A version of this article appeared in the June 2012 issue
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
2 Tech Stocks That Analysts Consider To Be Top