Gliding into balance: A glidepath approach to implementing risk parity

Risk-parity approaches to asset allocation, whereby investments are structured in a balanced way so that all asset groupings are expected to contribute equally to portfolio volatility, have received much attention in the past decade.

Approximately $150 billion in assets are held within asset management strategies that generally encompass the risk-parity universe. Risk-parity approaches can deliver many positive attributes, including superior diversification than is typically expressed within traditional institutional asset allocation policies. In this regard, risk parity can assist in managing against drawdown risk, as the strategies' pursuit of balance across market cycles can dampen portfolio vulnerability to specific economic and market regimes.

Despite the flow of assets into risk-parity strategies and the elevated level of attention they've attracted, many investors who have considered the approach have chosen not to deploy assets. There is a variety of reasons an institution might not find risk parity appropriate for meeting their organization's specific objectives, but the impediment most frequently cited is the current low-yield environment and concerns that interest rates are likely to rise in the future.

Because spreading risk equally across asset classes leads to larger relative weights to lower-volatility assets and smaller relative weights to more volatile assets, the resulting allocation mixes tend to produce portfolios with both low expected returns and risk. The typical risk-parity strategy therefore applies modest levels of leverage to these mixes to deliver them at return and risk levels intended to meet institutional return needs. When compared to traditionally diversified portfolios, which tend to have heavy risk concentration in growth assets such as public and private equities, risk-parity strategies tend to hold larger positions in high-quality fixed-income securities. It is this relative increase in bond exposure and its subsequent vulnerability to a rising rate environment that has discouraged many from investing in risk-parity strategies, even those that find the general asset allocation philosophy compelling.

While we disagree with the occasional assertion by some that risk-parity strategies are essentially levered bond strategies (they are better understood as leveraging of balanced low volatility asset mixes), we do understand concerns over increased exposure to yield-sensitive assets such as high-quality bonds. Further, while we do not think that there is ever a “bad time” to move toward greater diversification, the direct inverse relationship between yield shifts and fixed-income returns over the short term can make an increased exposure to bonds unsettling for investors who believe that interest rates will rise beyond the levels priced into fixed-income markets.

Investors concerned with the prospects of rising interest rates should consider a traditional glidepath approach to manage a transition of assets from today's allocations toward a suitable exposure to risk parity. This migration plan is appropriate for investors who appreciate the potential benefits of a risk-parity investment approach yet find themselves paralyzed from taking action in fear of rising yields. If concerns over an increase in rates are the true investment impediment, why not take that issue head on and enact a transition plan that directly manages against that risk?

As with other forms of glidepaths, developing an implementation plan requires establishing the following inputs:

• Starting allocation: the proverbial “Point A,” which does not include an allocation to risk parity.

• Target allocation: the proverbial “Point B,” which includes the targeted allocation to risk parity.

• A glidepath to follow in transitioning assets toward the targeted risk-parity allocation: a series of incremental portfolios that move the portfolio from “Point A” to “Point B.” Despite the “glidepath” label, one can think of this as a risk parity liftoff path.

• Trigger points: a path of incrementally increasing yield levels that serve as triggers to shift into the contingent portfolios along the risk parity glidepath

In practice, items two through four above would encompass many underlying considerations that require adaptation to meet each institution's unique needs and risk tolerances. The starting allocation is clearly the most straightforward input and is essentially defined by the portfolio's current asset mix. Depending on the ultimately determined role of risk parity within the final target portfolio, the starting allocation can either reflect total fund assets or a carved out subset of the fund.

Determining the scope of risk parity in the glidepath's endpoint (the second bullet in the list above) is an asset allocation decision. Therefore, as is the case with most other applications of glidepaths, its specific characteristics as well as the various steps along the glidepath (noted in the third bullet) should be addressed through a comprehensive asset-liability study. Among other considerations, the final decision regarding the number of steps and size of each along the glidepath should be driven by the overall required magnitude of change in moving from the current to the targeted allocation, as well as the investor's sensitivity to future interest rates. Below is a sample glidepath of moving from the current hypothetical 60/40 stock/bond portfolio to target allocations that incrementally step from a 0% to 40% risk-parity exposure contingent upon 10-year Treasury yields moving to 5% (the relative weights of stocks and bonds are held constant at 60/40 as they give up their combined weight to fund the risk-parity allocation).

As can be seen from the exhibit above, the shift into risk parity is directly contingent upon an increase in interest rates (in moving from left to right along the horizontal axis). There is no timetable associated with the transition, which allows risk parity implementation to naturally coincide with a reduction in the investor's concerns regarding the direction and level of future yields. The example above uses interest rate levels as trigger points because this is directly linked to the investment impediment noted earlier, although other triggering catalysts can be used if addressing other timing considerations. For example, if worried about relative performance variances that might not be directly linked to interest rate moves, a shift into risk parity can be dictated by a predetermined timetable, which is consistent with a traditional dollar-cost-averaging approach, or more directly to relative return differences between the current and risk parity allocations.

A risk parity glidepath framework is an ideal implementation plan for those institutions whose executives point to the current interest rate environment as the primary obstacle to adopting risk parity's balanced approach to harvesting market risk premiums. Putting such a plan in motion allows decision-makers to clearly articulate their desired asset mix and focus efforts on executing toward that target as market conditions warrant. This well-defined glidepath imposes an important level of discipline in shifting toward the desired balance. At the same time, the pacing and ultimate sizing of a risk-parity allocation can be revisited along with other strategic policy portfolio choices during future asset-liability studies.

Steven J. Foresti is a managing director of Wilshire Associates and chief investment officer of Wilshire Consulting in Santa Monica, Calif.