Risk parity has recently gained significant attention because of its strong performance compared to more traditional approaches of asset allocation in the last decade. While it has clear advantages, Yazann Romahi and Katherine Santiago reveal the challenges that risk parity investors should bear in mind when adopting this framework

The premise of risk parity as an approach to strategic asset allocation is based on maximal diversification of beta (or risk premia) as it emphasises the balanced contribution of various risk exposures to overall portfolio risk. However, much has been made recently of the increasing correlation among asset classes and the increasing difficulty of achieving diversification – particularly at times of crisis arising from systemic risk. These concerns are making investors rethink their traditional risk parity strategies.

In this article, we look at how a focus on risk premia, rather than traditional asset classes, can offer a much broader and more orthogonal set of factors investors can exploit. To illustrate the concept, we will focus on equity factor exposures.

A focus on risk factors

The difference between risk factor diversification and asset class diversification is subtle because when one refers to asset classes one is also referring to compensated risk premia.

These themselves are therefore factors. One can think of equities as a growth factor, treasuries as a deflation factor and commodities as an inflation factor. However, risk premia go much further than these traditional factors. In addition to those mentioned, for example, we can also include the equity value premium, the size premium, the forward rate bias and the merger arbitrage premium among others as further risk premia.

Extending risk parity in this direction can be seen to address the core concerns around traditional risk parity and can offer a very attractive approach to strategic asset allocation.

Equity risk premia – value, size and momentum

Going back to the early years of the fund management industry, prior to the development of indexation, investors attributed all of their return to the manager’s skill, or alpha. Over time, it became clear that a significant portion of these returns were driven by the stock market in aggregate and more importantly, that a return simply by being long the market.

This notion of there being a compensated return for simply owning the equity market led to the development of indexation.

Some active managers, however, continued to outperform the index by simply tilting towards low price-to earnings (P/E) and small cap stocks, introducing the idea of other priced risk factors beyond that of the market.

Long-term performance data also showed that positive momentum stocks outperform negative momentum stocks and that this is no different from tilting towards value or size.

These size, momentum and value premia are now widely regarded as separate risk premia from the equity market premium. However, there is still some debate as to the economic source of these premia, with some arguing that each is a reward for bearing systematic risk while others argue that there is an element of capturing market inefficiencies. Either way, there is overwhelming evidence for their persistence.

Most importantly, however, there is one clear departure from the traditional equity premium. To capture these other risk premia, there is a benefit from shorting as the value premium, for example, would be best captured by buying stocks with low P/E multiples while shorting those with high P/Es. Similarly, the size premium would be best captured by being long small cap stocks while shorting large cap stocks.

One of the most important consequences of looking at the equity market along these lines is the ability to create factors that are genuinely uncorrelated to each other.

Taxonomy of risk factors

By creating a risk parity strategy from factor risk building blocks rather than a traditional asset class perspective, we are able to address the key weaknesses of a traditional risk parity strategy, giving greater diversification as well as avoiding the concentration in duration or any single asset class.

For some investors, a full leap from asset class diversification to risk factor diversification may be difficult due to limitations on leverage, or because of an inability to exploit the short side given that key elements of factor-based asset allocation require more active rebalancing, the use of derivatives and short positions.

However, developments are taking place in the industry to allow investors to access these factors in a liquid and transparent fashion, many of which were previously inaccessible other than through higher cost, more opaque and less liquid vehicles.

A lot of these risk factors may already form part of an investor’s portfolio through value or small cap investments, or indeed through investments in convertible bonds. Therefore, the investor needs only to consider how to put them together in as orthogonal a way as possible and may be missing only a few additional factors that can be sourced elsewhere.

The requirement for shorting and leverage are two of the more significant hurdles for many investors. While we demonstrated that a long-only risk factor approach still does better than traditional balanced or risk parity approaches, a significant portion of the benefit is lost.

The purpose of a better diversified approach to risk parity is that all risk premia go through dislocations or extended periods where they are out of favour. Empirical evidence suggests that risk parity portfolios are the point of least regret and therefore are closer to ex post optimality than other forms of portfolio construction relying on the diversification benefits to feed through.

Isolating the risk premia at the factor level also leads to insight on the level of near-term return potential for the factor as the value associated with the factor is more transparent.

This can be used as a way to allocate around the strategic factor risk parity asset allocation benchmark.

An attractive approach to strategic asset allocation

By approaching risk parity using factor risk premia building blocks rather than traditional asset class definitions, investors are able to take advantage of the benefits of a risk parity approach while addressing the major concerns that more simplistic solutions have raised.

A pure approach is of most benefit, though long only investors can also benefit from looking at their portfolio in this innovative fashion.

Yazann Romahi is managing director and Katherine Santiago is vice president of J.P. Morgan Asset Management’s AM solutions, global multi-asset group

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