Parting the Fog Around Risk Parity
Quantitative investing, virtually unheard of 2 decades ago, has come a long way. While still the minority, quantitative managers now represent about a quarter of the hedge fund industry. Collectively, they managed one third of the industry’s assets or roughly USD 1 trillion.
Quant names also snagged the top 3 positions as the largest hedge funds in the world today – Bridgewater Associates (USD 160 billion), Renaissance Technologies (USD 110 billion), AQR Capital (USD 61 billion).
And just recently, one of our local hedge funds Vanda Global made the headlines as the top performing hedge fund in 2019, delivering a blistering 278%. The fund uses a “risk-weighted” approach towards active asset allocation globally.
Although there is no public information suggesting he is using a purely quantitative approach, its profile does resemble that of an increasingly popular allocation methodology known as Risk Parity.
What is Risk Parity?
Parity is just a sexier word for Equal. So in plain English, Risk Parity simply means Equal Risk.
The underlying concept is to allocate your capital among different assets or groups of assets such that each holds the same amount of risk.
It is actually not a novel approach in the hedge fund industry.
The theory behind Risk Parity went as far back as the 50s, and it was put into commercial practice in 1996 by Ray Dalio from Bridgewater Associates. He launched a hedge fund based on risk parity principles and named it the “All Weather Fund”.
This Fund was designed to do well in all market conditions, yet without the need to forecast how the market will unfold.
Sounds inconceivable?
This is the culmination of 3 things coming together: math, understanding of the markets, and common sense.
How is risk parity different from conventional allocations?
I am just going to illustrate with a simple 2-asset case. When it comes to asset allocations, most people never go beyond the mainstream 50/50 (50% stocks 50% bonds) or 60/40 (60% stocks 40% bonds). While such allocations looked nearly balanced in terms of dollars, they are actually far from balanced in terms of risks. Why? Because dollar for dollar, stocks are much riskier than bonds.
In fact, as much as 90% of the risks in a 60/40 portfolio comes from stocks. And I don’t think you need anyone to tell you how such a portfolio would perform in a bear market.
Maybe we can get around this if we can predict the market? No, we cannot predict the market and there is no need to.
Let’s leave fortune telling to the fortune tellers.
If that is the case, what is the best thing anyone can do?
A simple solution is to make sure you diversify your risks across a good mix of assets. Because there is a time for every asset. While one asset is under attack, another may be thriving. For example, stocks do well in bull markets but get thrashed in a bear. Good quality government issued bonds, such as US Treasuries, on the other hand, tend to do the reverse.
However, for this approach to work, it is critical that all assets play out evenly.
If one asset dominates over another, say stocks over bonds, then you are not reaping the maximum benefits out of diversification. That is the impetus behind sizing up the assets equally by risk. And this is the key principle underpinning Risk Parity.
So if you were to size up your allocation to stocks and bonds using risk parity, it would look like this instead.
How does the Outsized returns come about then?
A common argument against such an approach is that a large allocation to safe assets lowers the RETURN. That is true. But proponents of such opinions are missing out on the other half of the picture – RISK. Outsized returns from competent hedge funds is a result of well-managed risks and not just simply piling up on high risk assets. Let’s look at a backtest on a 2-asset portfolio comprising stocks and bonds built using Risk Parity from 2006 – 2019 against other portfolios.
It yielded the lowest risk with a decent CAGR with a smooth profile growing steadily. And the largest historical loss ever experienced is only a small -7.9%. If you were 100% into stocks, you would have lost more than half of your portfolio at one point in time. As a more objective measure, professionals also like to look at Returns Per Unit Risk (CAGR / Risk). The academic name for this measure is called Sharpe Ratio. Because that compares everything across a common denominator and we can see clearly here that Risk Parity gives you the best bang for the buck.
So how does that enable hedge funds to generate high returns? The answer is straightforward. They “borrow” money to size up their portfolio further because the lower risks provides them the scope to do so safely. In the industry, we call this leverage. You can do this through margin trading or buying leveraged products. Now, let’s look at what happen when we size up the Risk Parity portfolio by another 50% (note: all financing and trading costs are accounted for).
This buff up the Risk Parity portfolio’s CAGR to 9.3%, outdoing even a pure stock portfolio. Yet at the same, it has kept its risks low. And the largest historical loss under such a scenario is still a manageable -12.8%. So there is still room for even more leverage.
In fact, many hedge funds concentrate on building low risk strategies and then using leverage to amplify the returns. For the case of Vanda Global, it is running on a much higher leverage than what typical people or even hedge funds are willing to do. And for me, it is not so much their high returns that is impressive, but rather surviving the times that could have wiped out their portfolio on such high risks. And there were several such episodes since 2016. But having said that, for the average person with limited resources, such high leverage is not advisable and also not accessible.
Editor’s Notes – Risk Parity Is Now Open To All
The opening up of the technology world and the web has also now placed risk parity approaches into the hands of retail investors.
Computer costs are now cheaper than ever, the Internet is now the largest resource in the world, and professionals now have an onus to deliver higher returns.
If there was ever an open playing field, this is it. You can learn to do it yourself on the web. You can buy books, read articles.
