Volatility made an unwelcome but expected February return to the capital markets. The CBOE Volatility index's largest close-to-close point increase on Feb. 5 abruptly ended a period of unparalleled tranquility, marked by the index's all-time low just months prior.
Pundits and investors alike scrambled to identify the cause of these market gyrations and soon began crafting narratives that focused on increasing inflation expectations, growing concerns of rising interest rates and selling pressures from so-called "volatility targeting" strategies. This latter category included a menagerie of strategies, such as trend-following commodity trading advisers, VIX-linked exchange-traded products and risk parity strategies.
Risk parity's perceived role in the equity market sell-off and accompanying volatility spike was particularly notable, revealing what can only be described as a broad-based misunderstanding of the structure, implementation and influence of risk parity strategies by the financial press and many industry players.
It's easy to see how the unfamiliar investor could assume that risk parity is a homogenous investment product implemented in a standard, uniform fashion. But risk parity is, in actuality, an asset allocation philosophy embraced by a relatively small number of investment managers (fewer than 10 in our self-defined universe) with unique views and approaches. We need to tear down the all-risk-parity-funds-behave-the-same straw man and exonerate this strategy as a culprit in the recent market pullback.
The risk parity philosophy focuses on balancing the volatility contributions of a diversified pool of risk premiums. For allocation purposes, the risk premiums used within these strategies are typically grouped into three categories: growth related, deflation related and inflation related assets. Additionally, the strategies' overall volatility target tends to be roughly 10%, which mirrors the historical volatility of a traditional 60/40 portfolio. Nearly all risk parity managers will adhere to this framework of balancing risks across these broad asset categories.
But this is where the similarities end. An investment manager can structure a risk parity fund in many different ways, with the breakdown of asset categories among the biggest differentiators. As previously stated, asset classes are selected based on sensitivities to macro factors, such as rising or falling economic growth and inflation; but meaningful differences in exposures between risk parity funds still exist. Figure 1 highlights the range of asset classes that risk parity managers can use — from the most common, such as large-cap equities and investment-grade bonds, to the more unique investments, like inflation-linked derivatives products that can drive meaningful performance dispersion between funds over shorter time periods.
It's also important to understand the various compositions of managers' asset class exposures. For example, while many risk parity managers adhere to classic capitalization-weighting to gain exposure to global developed equities, others practice a "parity-within-parity" approach. This technique involves equally weighting sectors, countries or individual securities on a risk-contribution basis where sectors or stocks with lower historical volatility will have a higher capital weight in the portfolio, relative to those with higher historical volatility.
Using the MSCI World index as a proxy for cap-weighted global equities and the MSCI World Risk-Weighted index as a proxy for a parity-within-parity approach, Figure 2 shows the rolling three-year cumulative performance differential between the two indexes. While both reflect long-only global equity exposure, they can deliver extremely different outcomes for investors over shorter time periods, with the three-year performance differential reaching double digits as recently as 2014. Given that the risk-weighting to global developed equities is typically about 33%, this seemingly minor difference in portfolio construction can actually cause significant performance dispersion among risk parity funds over time.
A manager's definition of risk is, by far, the largest differentiator and most misunderstood aspect of risk parity. A strategy that allocates capital based on contribution to risk must have a well-defined measure of volatility. Risk parity managers' definitions of risk can vary in significant ways, particularly time frame. For instance, while some managers prefer to calculate volatility on a longer (i.e., 1,500-day) timescale, other managers prefer to use a short-term measure, such as 60-day trailing — each of which will have different ramifications for the portfolio. As risk parity managers seek to maintain a particular risk contribution from each asset category, a short-term spike in volatility may require a reduction in capital exposure from those managers who use short-term measures. However, the same short-term volatility spike will have little to no effect on a portfolio constructed using a longer-term volatility measure.
Figure 3 illustrates multiple Standard & Poor's 500 volatility measures, as determined by standard deviation, for the 12 months through February. The February VIX peak also coincided with an increase in short-term volatility (60- or 120-day). Therefore, risk parity managers who employ short-term risk calculations (a small minority) would have needed to reduce equity exposure shortly thereafter to maintain their target risk contributions. Alternatively, those utilizing longer-term risk measures would have barely noticed the increase in volatility and would have most likely maintained a more static equity exposure throughout the month.
An examination of risk parity managers' supposed uniformity in 2015 illustrates the last major example of risk parity's role as a scapegoat for market volatility. During the summer of that year, as concern about the Chinese economy prompted a spike in volatility, risk parity was accused of exacerbating the sell-off. In reality, given the variety of approaches to managing risk parity portfolios, there was no indiscriminate slashing of equity exposures performed in unison across the risk parity universe. In fact, considerable heterogeneity existed among risk parity managers in 2015, with dispersion in yearly returns exceeding 5.5% within our manager universe.
Clear and significant differences in asset classes, construction techniques and — most acutely — risk measures, provide a clear refutation of the narrative that risk parity is a generic, undifferentiated influence on the capital markets. And these facts, paired with large performance dispersion during periods of heightened volatility, cast significant doubt on the role that this strategy played in February's market turmoil.
Jim Smigiel is head and chief investment officer of absolute return strategies at SEI Investments (SEIC) Co., Oaks, Pa. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.