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Asset Management Viewpoints

Capturing the Equity Premium

by Erik Gosule

From what you are saying it sounds as if risk parity, or a balanced weighting of risk in a portfolio, is a passive strategy.

I like to think of risk parity as being the ultimate passive equity investment strategy. It is an agnostic approach that essentially expresses no implied view that one particular attribute is likely to outperform another on a risk-adjusted basis because the approach mitigates such risk concentration within the portfolio. To invest in a cap-weighted fund or other portfolios built using processes that result in some form of risk concentration generally implies that one believes that certain sectors, countries, or other such concentrations will outperform on a risk-adjusted basis. They may, but then again they may not. Or they may perform for a while, then cause the fund to experience a drawdown that more than wipes out that performance.

From this standpoint, investing in a cap-weighted index—even in a passive index tracking fund—is somewhat akin to investing with an active manager. With an active manager, you are betting on his selection of market bias. With a cap-weighted index tracker, you are betting on the inherent bias in the index. To the extent that a fund wishes to express a view that low-volatility strategies will outperform—because it believes that there is a strong possibility that recent volatility is going to persist and damage performance—we would still argue that applying an approach based on risk parity to target low-volatility stocks will generate better risk-adjusted returns.

As an example, during the dot.com crash, which ran from April 2000 to the end of September 2002, the cap-weighted index fell by some 45%. Our diversified risk portfolio fell by just 16%. This makes it a great deal easier for a diversified risk portfolio to recover from a downturn. The October 2008–April 2009 global financial crash saw the cap-weighted index drop by almost 48%. This time around diversified risk portfolios suffered as well, since the crash was all-encompassing, but they fell by just 41%. Applying the diversified risk process to a portfolio that was targeting lower-volatility stocks would have further mitigated drawdowns during these periods.

However, a characteristic that distinguishes the approach from other low-volatility strategies is that, in addition to mitigating downside and reducing volatility in difficult periods, an approach based on risk parity often participates in the market’s upside during periods of strong performance. As markets recovered in the latter half of 2009, the diversified risk strategy strongly outperformed many low-volatility approaches.

It sounds simple, balancing out risk, but in practice it looks like being a very complicated exercise, since when you balance risk in one direction you find you are increasing it in another.

It is not a simple exercise. As you say, balancing one dimension can have knock-on effects on other risk dimensions. It has taken us a very significant investment of time and skill to solve the problems associated with viable risk balancing. You have to consider all the trade-offs that are relevant to do this. In addition, you have to put a significant amount of resources into the effort. It is not easy for any fund management house to simply shift from what they may be doing today—whether it is offering a low-volatility fund or a long short strategy—and produce a risk parity fund that is actually going to do what it says on the tin.

So you would say that the Sharpe ratio, a measure of return per unit of absolute risk, is more important as a performance measure for your strategy than any attempt to provide a tracking error against a benchmark?

Exactly. We believe that the most efficient capture of the equity risk premium is what we are after. The Sharpe ratio is indicative of the amount of return (in excess of the risk-free rate) that an investor receives for each incremental unit of risk they take on. Our back-testing of the diversified risk approach shows a greater than 100% improvement in the Sharpe ratio by comparison with cap-weighted funds over time, and we have seen similar relative results since launching our first non-US diversified risk strategy.

We have found the diversified risk approach to be quite robust. Our research shows that the approach adds value in every region and virtually every sector. The one area that we have discovered where a risk parity approach struggles to outperform a cap-weighted index is in the technology sector. Within this sector much of the performance is heavily concentrated in a handful of stocks, with Apple and Google dominating for example. A few stocks driving the whole of a sector can be very good for the sector for a while, but when they run out of steam it can have a profound effect on the whole sector.

Interestingly, our findings show that the diversified risk approach is a good strategy even where you are trying to construct a portfolio that is tilted toward exposures which are intended to generate higher returns because balanced risk exposure is something that adds value to almost any portfolio that benefits from diversification. You can balance risk across and within many dimensions. When constructing a risk parity portfolio, you begin by identifying the various risk dimensions, then you solve for the weight that achieves the risk exposure you want for the strategy. It is important to realize that this is a very systematic approach and the portfolio will always maintain a balanced risk allocation. Once the selection is made, we continuously monitor portfolios to ensure that the risks remain balanced and that a portfolio is not wandering away from the key parameters over time. What this means is that if there are external shocks to the market, or if the business cycle changes, the portfolio should be able to weather the storm.

In contrast, if you are in a cap-weighted fund, you will be in more cyclical stocks, and when the business cycle changes your fund will lose performance. With a minimum-variance approach, for example, the reverse is true and you will be too defensively positioned if the business cycle moves into a more positive phase.

In conclusion, there are clearly far-reaching events that can happen that are going to cause a shock regardless, and there are circumstances in which no equity portfolio can outperform. However, a risk parity approach is clearly better at capturing the equity premium over a wide range of conditions.

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Further reading

Books:

  • Grinold, Richard C., and Ronald N. Kahn. Active Portfolio Management: A Quantitative Approach for Providing Superior Returns and Controlling Risk. 2nd ed. New York: McGraw-Hill, 1999.
  • Mackay, Charles. Extraordinary Popular Delusions and the Madness of Crowds. 1841. Online at: www.gutenberg.org/ebooks/24518
  • Qian, Edward E., Ronald H. Hua, and Eric H. Sorensen. Quantitative Equity Portfolio Management: Modern Techniques and Applications. Boca Raton, FL: Chapman & Hall/CRC, 2007.
  • Shiller, Robert. Irrational Exuberance. 2nd ed. New York: Broadway Books, 2006.

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