Risk parity VS factor-based risk parity

Risk parity
Risk Parity

Risk parity has become progressively more popular with institutional investors who are ill at ease with the unstable risk profile of a conventional “balanced” equity and bond portfolio.

This is according to a new paper released by JP Morgan Asset Management’s Global Multi Asset Group which discusses the benefits of risk factor diversification for institutional owners.

Risk parity is another approach to investment portfolio administration which centres on the distribution of risk rather than the distribution of capital.

This method dictates that when asset allocations are adjusted (leveraged or deleveraged) to the same level of risk, the risk parity portfolio can reach a higher Sharpe index (which measures the excess return per unit of deviation in an investment strategy) and can be more opposed to market slumps than the conventional portfolio.

Investment strategies based on risk parity focus on decreasing equity weightings to balance out the risk shares of the equity and bond exposure, then adjusting the bond exposure to recompense for the loss of expected return.

Part of the recent success of risk parity tactics has been a consequence of their dependence on leveraged fixed income during a rising market for bonds.

Including a broader range of factors in risk parity-type portfolios could assist investors to carry on attaining the risk-adjusted returns they require.

The principle behind risk parity as an approach to tactical asset distribution is founded on maximum diversification of beta, as it highlights the balanced contribution of a variety of risk exposures to overall portfolio risk.

Beta is a number that describes the related unpredictability of an asset in relation to the unpredictability of the standard that the asset is being compared to.

In the report, the fund proposes a more widespread approach to building risk parity portfolios, based on factor risk premia instead of conventional asset class diversification which might lead to unplanned correlation.

Expanding risk parity in this way can tackle the central issues surrounding traditional risk parity.

“The main benefit of approaching asset allocation from a factor perspective is the diversification benefits achievable over constructing portfolios using more traditional asset class definitions,” said Yazann Romahi, head of Quantitative Portfolio Strategies at the company.

Factor risk parity departs from numerous hallmark features of risk parity.

It unequivocally takes the market into account, during both day-to-day portfolio management and the allocation process.

For some investors making a complete change from asset class diversification to factor diversification might be very hard to do.

Factor-based asset allocation needs more vigorous rebalancing, short positions and the use of derivatives so the change could be difficult due to an inability to take advantage of the short side or because of limitations on leverage.

Strengthening a portfolio in this context means exploiting the structural inefficiencies within the equity market. This inevitably leads to shorting.

Shorting, along with leveraging and widespread derivative use, would be a difficult departure for many institutional funds.

Conventional risk parity may even be too challenging based on these issues for many asset owners, let alone factor-based risk parity.

Tim Walsh, head of New Jersey’s state pension system told aiCIO that he was not interested in risk parity at the moment because it involves too much leveraging.

Lombard Odier’s asset allocation is based on a precise process which takes into account current macroeconomic factors and various indicators for valuing asset classes, measuring the premium for the risk incurred, and understanding the general market confidence level.

Favouring a long-term view with strict risk management, Lombard Odier constantly amends and fine-tunes its allocations according to interior and exterior events swaying the markets.