Diversification: Still the only free lunch?

Alternative building blocks for risk-parity portfolios

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Risk parity has recently garnered significant attention, particularly owing to its strong performance in the last decade. The premise of risk parity as an approach to strategic asset allocation is based on maximal diversification of beta (or risk premiums). However, investors are keenly aware of the increasing difficulty of achieving asset class diversification — particularly in times of crisis.

A number of recent studies have examined the benefits of factor diversification over asset class diversification. The difference is subtle because asset classes are themselves factors (i.e., compensated risk premiums). Equities can be thought of as a growth factor, Treasuries as a deflation factor and commodities as an inflation factor. However, risk premiums extend beyond these traditional factors and can also include, for example, the equity value premium, commodities roll yield and the merger arbitrage premium.

This paper seeks to shed light on risk parity, outline its main advantages and address investors' current concerns with the framework. In our view, by using factor premiums as the building blocks of risk parity, one can address the core concerns around traditional risk parity and offer a very attractive approach to strategic asset allocation.

Concerns with traditional methods

Traditional balanced portfolios with a 60/40 mix between equities and bonds might sound diversified, but stocks account for approximately 90% of the volatility of these portfolios. Risk parity addresses this imbalance by emphasizing balanced risk contributions from each asset class. The solution can be simply achieved by leveraging the bond portfolio and reducing the reliance on equity returns which, in risk terms, better diversifies the portfolio. However, there are two major concerns with this method of portfolio diversification.

Concern 1: Leveraging risk premiums with poor return expectations.

Government bonds are an example of a risk premium less likely to prove attractive going forward, given current exceptionally low levels of yield. Unfortunately, this is precisely the asset class that traditional risk parity typically leverages.

Today's yield levels are not unprecedented; similar levels were seen in the 1950s. As yields rose over the subsequent 30 years, bond investors underperformed cash (earning 3.9% on bonds vs. 4.3% on cash). In contrast, the period from 1981 onward — the period that most proponents of risk parity have studied — has been a particularly attractive period for leveraged duration investments, characterized by consistent disinflation and falling yields. A repeat of the 14% yield contraction seen over this period, starting from today's levels, is of course, impossible.

Concern 2: Correlation and hybrid asset classes

As a portfolio construction method, risk parity removes sensitivity to returns and correlation forecasts, instead making the fundamental assumption that the building blocks are truly uncorrelated. Some proponents of risk parity have included regional equity allocations in an attempt to diversify the exposure. However, increasing globalization has led to increasing correlations among regional equity markets, reducing opportunities for diversification.

Asset managers have also been adding hybrid asset classes, such as convertible bonds, to increase diversification. Unfortunately, convertible bonds have a high level of correlation to traditional asset classes. The equity component is made up of a small-cap premium as well as an equity premium, while the bond component is a combination of credit and duration. The illiquidity premium associated with the embedded optionality of the convertible bond itself, however, is unique to the asset class. Therefore, when investing in convertible bonds in order to capture this unique risk premium, it is important to take into account the debt and equity premiums that are often present elsewhere in the portfolio as well.

Alternative beta and factor risk premiums

Exhibit 1

Understanding sources of return beyond equity and bond returns has been a key focus of academic research. This has spawned the work on alternative beta by contributing to the realization that a significant portion of hedge fund returns often comes from these risk premium exposures rather than pure skill. Essentially, these factors are systematic exposures that are rewarded with a return above the risk-free rate, uncorrelated to traditional asset classes.

Factors are not a new concept in fund management. Over time, active equity managers have consistently outperformed the broad market index by simply tilting toward low price-to-earnings ratios or small-cap stocks. The Fama-French model introduced the idea of priced risk factors beyond that of the market. Specifically, the model identified the persistent outperformance of value and small-cap stocks from 1927 to the present day.

However, there is a critical distinction between traditional and alternative equity premiums. To capture these other risk premiums, there is a benefit from shorting. For example, the size premium is isolated by buying 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 generally uncorrelated factors. As Exhibit 1 illustrates, the average rolling three-year correlation among four equity regional markets is clearly stronger and more distinctively upward-trending, as a result of globalization, than the correlation across the four equity factors.

Factor risk parity

Exhibit 2: Taxonomy of risk factors
Traditional beta Alternative beta
Equity premium Commodity (GSCI) Small-cap premium Relative bond carry
Credit premium Emerging debt Value premium Relative bond yield curve
Term premium Emerging equity Equity momentum Convertible arbitrage
REIT Minimum volatility Merger arbitrage
Commodities momentum Commodities roll yield
FX momentum Forward rate bias

Exhibit 2 shows the wide range of factor risks that have been identified in the literature. To the left are the components of a traditional risk parity strategy and to the right, the broader set of alternative risk premiums. Our research has shown that when both sets of premiums are incorporated into a factor risk-parity framework, the portfolio's risk/return profile is dramatically improved. Factor risk parity consistently outperformed traditional risk parity across all time periods studied, inclusive of both rising and falling yield environments.

Many of these factors may already form part of an investor's portfolio, but investors need to be able to extract and more efficiently combine them. Developments are taking place in the industry to allow these factors to be accessed individually in a more liquid, low-cost and transparent fashion than previously possible.

While an increasing number of investors are using or considering risk parity, there remains some hesitation. However, by approaching risk parity using factor risk premium building blocks rather than traditional asset class definitions, investors can take advantage of the benefits of a risk parity approach while addressing the major concerns that more simplistic solutions have raised.

Yazann Romahi is managing director and head of quantitative portfolio strategies, and Katherine Santiago is vice president, portfolio manager, quantitative portfolio strategies global multiasset group, at J.P. Morgan Asset Management (JPM) in London.