Risk Parity: A Different Take on Diversification
With global economic momentum expected to weaken in 2019 and uncertainty clouding most outlooks, we believe it is important for investors to consider the extent to which diversification is deployed in their portfolio. Most investors appreciate that combining risk assets with bonds can improve the risk-adjusted return of their portfolios. While this is a good first step, maximizing diversification requires applying the concept to the entire depth and breadth of a portfolio.
Here is our common sense definition of diversification: the degree to which long-run portfolio outcomes are determined by a multitude of unrelated drivers. As Risk Parity investors, we apply diversification within and across asset classes, and across time. We think these additional lenses of diversification help maximize an investor’s probability of success in strategic asset allocation.
- Diversification within asset classes means investing in asset-class-level portfolios that spread risk across countries and sectors as broadly as possible. Our research shows that diversification within asset classes can rival the outcome of top-quartile tactical allocations, without taking the risk associated with betting on any single market or attempting to forecast returns. This is why the bar for tactical asset allocation is so high in our view—the diversified portfolio is the opportunity cost against which tactical asset allocation ought to be measured.
- Diversification across asset classes means allocating portfolio risk to asset classes that behave differently (i.e., primary asset classes). Compared against most traditional balanced portfolios, this means re-allocating significant risk—the bulk of it, in fact—from equities to asset classes like sovereign fixed income, credit spreads and commodities. That is a radical shift, but we believe this has the ability to help improve the risk-adjusted return of the strategic mix of assets, even when some of the diversifying asset classes fail to perform on their own.
We believe diversifying across primary asset classes can add value over the long run by delivering exposure to diverse macro-fundamental drivers and mitigating the more dramatic boom-and-bust return profile associated with concentration in a single asset class. This is the core philosophy of risk parity: a balanced allocation of risk across asset classes rather than an allocation of capital.
- Diversification across time means building and actively managing the risk of a portfolio so that no subset of the investment horizon has a disproportionate impact on the long-run portfolio outcome. Diversification across time helps ensure performance is not excessively influenced by any one portfolio driver, where drivers can include not only asset classes and individual markets, but also periods of time. Sharp or prolonged equity declines can have enormous influence on the terminal value of traditional portfolios. The reason is that traditional balanced portfolios take more risk during periods of high market volatility than they do during periods of low market volatility. If returns were as likely to be good as bad when volatility rises, an investor should still reduce risk because higher volatility leads to increased uncertainty about the future. Active risk management trims position sizes as market risk rises, keeping the expected impact of a one-day move consistent through time and helping to mitigate the disproportionate impact volatile markets typically have on long-term investment outcomes. Time diversification can also help portfolios squeeze meaningful return from quiet markets, enhancing the number of unrelated drivers of long-run investment outcomes.
Delivering True Diversification
Most investors never fully consider diversification as a way to potentially improve the odds of achieving high target portfolio returns because, in most investors’ minds, diversification leads to lower return. Risk Parity breaks the link between diversification and lower return by using moderate leverage to convert a more efficient portfolio into one that is designed to generate a high return at an acceptable level of risk. In constructing our Risk Parity strategy, we consistently seek to target balanced risk within and across asset classes and across time, going well beyond conventional diversification.
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