Skip to main content
MENU
Subscribe
  • Sign Up Free
  • LOGIN
  • Subscribe
  • Topics
    • Alternatives
    • Consultants
    • Coronavirus
    • Courts
    • Defined Contribution
    • ESG
    • ETFs
    • Face to Face
    • Hedge Funds
    • Industry Voices
    • Investing
    • Money Management
    • Opinion
    • Partner Content
    • Pension Funds
    • Private Equity
    • Real Estate
    • Russia-Ukraine War
    • SECURE 2.0
    • Special Reports
    • White Papers
  • Rankings & Awards
    • 1,000 Largest Retirement Plans
    • Top-Performing Managers
    • Largest Money Managers
    • DC Money Managers
    • DC Record Keepers
    • Largest Hedge Fund Managers
    • World's Largest Retirement Funds
    • Best Places to Work in Money Management
    • Excellence & Innovation Awards
    • WPS Innovation Awards
    • Eddy Awards
  • ETFs
    • Latest ETF News
    • Fund Screener
    • Education Center
    • Equities
    • Fixed Income
    • Commodities
    • Actively Managed
    • Alternatives
    • ESG Rated
  • ESG
    • Latest ESG News
    • The Institutional Investor’s Guide to ESG Investing
    • ESG Sustainability - Gaining Momentum
    • Climate Change: The Inescapable Opportunity
    • Impact Investing
    • 2022 ESG Investing Conference
    • ESG Rated ETFs
  • Defined Contribution
    • Latest DC News
    • DC Money Manager Rankings
    • DC Record Keeper Rankings
    • Innovations in DC
    • Trends in DC: Focus on Retirement Income
    • 2022 Defined Contribution East Conference
    • 2022 DC Investment Lineup Conference
  • Searches & Hires
    • Latest Searches & Hires News
    • Searches & Hires Database
    • RFPs
  • Performance Data
    • P&I Research Center
    • Earnings Tracker
    • Endowment Returns Tracker
    • Corporate Pension Contribution Tracker
    • Pension Fund Returns Tracker
    • Pension Risk Transfer Database
    • Future of Investments Research Series
    • Charts & Infographics
    • Polls
  • Careers
  • Events
    • View All Conferences
    • View All Webinars
    • 2023 Defined Contribution East
    • 2023 ESG Investing
Breadcrumb
  1. Home
  2. INVESTING & PORTFOLIO STRATEGIES
November 15, 2012 12:00 AM

Diversification: Still the only free lunch?

Alternative building blocks for risk-parity portfolios

Yazann Romahi and Katherine Santiago
  • Tweet
  • Share
  • Share
  • Email
  • More
    Reprints Print
    istockphoto

    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

    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.

    Exhibit 2: Taxonomy of risk factors
    Traditional beta Alternative beta
    Equity premiumCommodity (GSCI) Small-cap premiumRelative bond carry
    Credit premiumEmerging debt Value premiumRelative bond yield curve
    Term premiumEmerging equity Equity momentumConvertible arbitrage
    REIT Minimum volatilityMerger arbitrage
    Commodities momentumCommodities roll yield
    FX momentumForward 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 in London.

    Related Articles
    The end to the bull market in bonds
    Recommended for You
    More funds testing water on crypto-related assets
    More funds testing water on crypto-related assets
    Money managers eager to make leap to opportunity zone investing
    Money managers eager to make leap to opportunity zone investing
    Index investing: Not as passive as you might think
    Index investing: Not as passive as you might think
    The Institutional Investor's Guide to ESG Investing
    Sponsored Content: The Institutional Investor's Guide to ESG Investing

    Reader Poll

    January 25, 2023
    SEE MORE POLLS >
    Sponsored
    White Papers
    Show Me the Income: Discovering plan sponsor and participant preferences for cr…
    The Future of Infrastructure: Building a Better Tomorrow
    Outlook 2023: Opportunity in a volatile world
    Research for Institutional Money Management
    View More
    Sponsored Content
    Partner Content
    The Industrialization of ESG Investment
    For institutional investors, ETFs can make meeting liquidity needs easier
    Gold: the most effective commodity investment
    2021 Investment Outlook | Investing Beyond the Pandemic: A Reset for Portfolios
    Ten ways retirement plan professionals add value to plan sponsors
    Gold: an efficient hedge
    View More
    E-MAIL NEWSLETTERS

    Sign up and get the best of News delivered straight to your email inbox, free of charge. Choose your news – we will deliver.

    Subscribe Today
    December 12, 2022 page one

    Get access to the news, research and analysis of events affecting the retirement and institutional money management businesses from a worldwide network of reporters and editors.

    Subscribe
    Connect With Us
    • RSS
    • Twitter
    • Facebook
    • LinkedIn

    Our Mission

    To consistently deliver news, research and analysis to the executives who manage the flow of funds in the institutional investment market.

    About Us

    Main Office
    685 Third Avenue
    Tenth Floor
    New York, NY 10017-4036

    Chicago Office
    130 E. Randolph St.
    Suite 3200
    Chicago, IL 60601

    Contact Us

    Careers at Crain

    About Pensions & Investments

     

    Advertising
    • Media Kit
    • P&I Content Solutions
    • P&I Careers | Post a Job
    • Reprints & Permissions
    Resources
    • Subscribe
    • Newsletters
    • FAQ
    • P&I Research Center
    • Site map
    • Staff Directory
    Legal
    • Privacy Policy
    • Terms and Conditions
    • Privacy Request
    Pensions & Investments
    Copyright © 1996-2023. Crain Communications, Inc. All Rights Reserved.
    • Topics
      • Alternatives
      • Consultants
      • Coronavirus
      • Courts
      • Defined Contribution
      • ESG
      • ETFs
      • Face to Face
      • Hedge Funds
      • Industry Voices
      • Investing
      • Money Management
      • Opinion
      • Partner Content
      • Pension Funds
      • Private Equity
      • Real Estate
      • Russia-Ukraine War
      • SECURE 2.0
      • Special Reports
      • White Papers
    • Rankings & Awards
      • 1,000 Largest Retirement Plans
      • Top-Performing Managers
      • Largest Money Managers
      • DC Money Managers
      • DC Record Keepers
      • Largest Hedge Fund Managers
      • World's Largest Retirement Funds
      • Best Places to Work in Money Management
      • Excellence & Innovation Awards
      • WPS Innovation Awards
      • Eddy Awards
    • ETFs
      • Latest ETF News
      • Fund Screener
      • Education Center
      • Equities
      • Fixed Income
      • Commodities
      • Actively Managed
      • Alternatives
      • ESG Rated
    • ESG
      • Latest ESG News
      • The Institutional Investor’s Guide to ESG Investing
      • ESG Sustainability - Gaining Momentum
      • Climate Change: The Inescapable Opportunity
      • Impact Investing
      • 2022 ESG Investing Conference
      • ESG Rated ETFs
    • Defined Contribution
      • Latest DC News
      • DC Money Manager Rankings
      • DC Record Keeper Rankings
      • Innovations in DC
      • Trends in DC: Focus on Retirement Income
      • 2022 Defined Contribution East Conference
      • 2022 DC Investment Lineup Conference
    • Searches & Hires
      • Latest Searches & Hires News
      • Searches & Hires Database
      • RFPs
    • Performance Data
      • P&I Research Center
      • Earnings Tracker
      • Endowment Returns Tracker
      • Corporate Pension Contribution Tracker
      • Pension Fund Returns Tracker
      • Pension Risk Transfer Database
      • Future of Investments Research Series
      • Charts & Infographics
      • Polls
    • Careers
    • Events
      • View All Conferences
      • View All Webinars
      • 2023 Defined Contribution East
      • 2023 ESG Investing