Note: This article is courtesy of Iris.xyz
By Dr. Sonu Varghese
An interesting article in the Wall Street Journal discussed concerns that risk-parity funds could be forced to sell amid surging volatility, exacerbating the sell-off. Risk-parity funds build portfolios based on “risk” (or volatility in its simplest form), as opposed to dollar weights. A traditional 60-40 stocks-bonds portfolio actually has about 90% of its total risk coming from its allocation to stocks. In its simplest form, risk-parity seeks to have a more equitable allocation to risk from its allocations.
Bridgewater, headed by Ray Dalio and one of the largest hedge funds in the world, was one of the first firms to implement a risk-parity portfolio in 1996 called the “All Weather Portfolio”. Quoting from their white paper, The All Weather Story:
“Low risk/low-return assets can be converted into high-risk/high-return assets.” Translation: when viewed in terms of return per unit of risk, all assets are more or less the same. Investing in bonds, when risk-adjusted to stock-like risk, didn’t require an investor to sacrifice return in the service of diversification. This made sense. Investors should basically be compensated in proportion to the risk they take on: the more risk, the higher the reward.
This results in a high volatility asset like stocks making up only a small portion of the portfolio, while low volatility assets like bonds dominate. A key element of this is for these assets to be negatively correlated with each other (as we will see below).
Risk parity portfolios have only gotten more popular over the previous decade as yields collapsed, including at AQR Capital Management LLC, which managed $26.6 billion in risk-parity strategies as of June. Note that commodity trading advisors have used volatility based position sizing since at least the 1980s.
As the WSJ article points out, risk-parity funds hold a significant amount of bonds (sometimes with leverage), leaving them vulnerable when stocks and bond prices fall rapidly, as happened on Friday (9/9) and Tuesday (9/13). If this occurs for a sustained period of time, they could be forced to delever and sell investments, further intensifying the sell-off.[related_stories]
Let’s take a look at how this could happen using a simple example.
Consider a basic, un-levered risk-parity portfolio which holds 25% in stocks and 75% in bonds. Say in a ‘normal’ low volatility environment, stocks exhibit a volatility of 12% and bonds 4%. Also assume that the correlation between stocks and bonds during such normal times is -0.5.
We can then calculate the volatility (or standard deviation) of this two asset portfolio as 3%.
Now, correlation is a crucial component of risk parity portfolios. To see why, let’s assume the correlation between stocks and bonds to be 0, instead of -0.5. The portfolio volatility rises to 4.2%.
In other words, we lose some of the diversification benefit if we assume stocks and bonds are completely uncorrelated with each other, as opposed to being negatively correlated.