Jean-Louis Nakamura and Jérôme Teiletche : «risk-parity portfolios provide real diversification »

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What is the Risk-Parity approach?

Risk-parity approach has developed as an alternative to traditional portfolio construction. This is an agnostic and systematic approach . It is based on the idea that in the absence of views on the assets, the most efficient portfolio is the one that is more diversified. Thus, this investment strategy is to equalize the risk contributions of the different components of a portfolio. The fact to diversify in risk and not in capital is one of the founding brands of this approach and, in some very concrete situations, it makes a difference. For example, if a classic Global balanced portfolio appears diversified when viewed in terms of capital – as it is made of 50% equities and 50% bonds – its structure is totally biased, since nearly 90% of its volatility – and therefore fluctuations in its returns – will only come from equities.

Who is Using this approach?

Risk parity approach is a growing interest and, for example, more and more pension funds are redefining all or part of their strategic asset allocation – ie long-term – around such concepts. Their motivation is that the portfolios built in this way seem to offer risk-adjusted returns superior to traditional approaches with more limited drawdown. For our part, we have now repositioned a very important part of our multi-asset classes (Global Balanced) portfolios around such concepts for nearly three years and this allowed us to post more consistent performances (and still significantly positive this year) in fast-moving markets. But also we increasingly apply this approach in asset classes such as stocks or commodities. In this context, the funds selectors are also interested in these investment products.

Better risk-adjusted returns: how is this possible?

It is fair to say that, as with related portfolios that aim to minimize the risk, the academic literature has not found unanimous theoretical explanations of why these portfolios appear to outperform. Various explanations are advanced, however, valid for different approaches to “low risk”. Securities with low beta (low systematic risk) would be shunned by investors who find them “too soft” and they will then show superior risk-adjusted returns. The markets asymmetric reaction – including equities- to good and bad news would also make that, on the whole cycle, it is better to hold securities with low beta. there is no doubt about the academic literature, which focuses more and more on the subject, will progress in the rationalization of the phenomenon but for now, it’s more empirical observation and “common sense” associated with such portfolios that reinforce investors.

What are the limitations of this approach?

The main criticism addressed to the Risk parity is about its performance, which if significantly higher when risk-adjusted, may be less ambitious in the absolute. This is debatable. On the one hand, this result is especially true for Global balanced portfolios and not really true for asset classes like stocks. Within the Global balanced portfolios, we can further compensate for this effect by using leverage. Finally, with performance close to 8% over the last twelve years against yields below 4% for a more classical approach, it is unclear whether it is an empirically valid point. While acknowledging that the very strong performance of the bond market related to the disinflation and the recurrence of crises give a little bias to these results.

Another problem is that some investors are sometimes frustrated by the agnostic nature of this process, which deliberately does not include views about the market. He likens this to a quantitative black box. The goal is different in our opinion: This is about defining a process of portfolio strategic rebalancing that provides non-emotional discipline and delivers stable results. And if it is an interesting solid foundation, there is no requirement to stop at that.

Exactly do you combine this approach with others?

Risk parity approach, which is to dynamically change long positions in various risk premiums such as stocks, bonds or commodities, is favorably combined with a tactical long-short approach which aims to generate alpha. In our Global Balanced portfolios, it essentially takes the form of a global macro alpha or GTAA alpha, namely equity long and short positions on traditional asset classes via liquid and flexible instruments. we can consider grafting trend-following or alpha systems based on the selection of securities (equity market neutral type). These alpha can be systematic or discretionary but it is especially important that we have full transparency on the related portfolios to ensure that they are well grafted in terms of risk diversification and not in a pure addition of the latter