This document extends our earlier study1 which provides a comparison of ex ante risk parity allocations with the ex post optimal portfolio2. Our prior work showed that when the investment opportunity set consists of two assets—stocks and bonds—ex ante risk parity performs on par with the optimal allocation, despite being allocated using less information. This finding has profound implications for asset allocation because it implies that risk parity may offer a proxy for the long-run optimal portfolio and serve as the basis for an implementable version of Modern Portfolio Theory (MPT).
We start with a quick review of MPT, which motivates us to focus on risk-adjusted returns as the proper metric for quality of an asset allocation. We then discuss the conditions under which a risk parity allocation in fact provides the highest possible risk-adjusted return available to market participants. Using a long historical dataset of U.S. Equity, 10-Year U.S. Treasury, and Commodity Futures returns, we show that one of these two conditions likely does not hold and statistically reject the possibility that risk parity generates precisely the maximum Sharpe ratio portfolio (MSRP).3 However, risk-adjusted returns on the parity allocation are quite similar to the optimal portfolio.4 Having placed risk parity into its proper theoretical context, we next examine the historical performance of an implementable risk parity strategy, which is allocated historically based on data that would have been available at the time of each rebalance. We find that this implementable version of risk parity also performs on par with the MSRP, confirming findings in our earlier work, which considered a shorter time period and fewer asset classes.
In section 3 we examine the economic intuition for why a risk parity portfolio might be expected to perform on par with the long-run optimal portfolio. We show that the three asset classes we are considering here each perform differently in different macroeconomic environments, making them solid building blocks for a risk parity strategy. Because the macro economy went through phases that favored each asset class during the historical period we study, we find that the average implementable risk parity allocation is very similar to the ex post optimal MSRP.
The Global Financial Crisis brought with it a resurgence of interest in tail risk, both within the financial services industry and the academic world. However, tail risk has been an important topic in financial literature since academic researchers realized that market returns often violate normality assumptions. In this article, we provide a brief literature review of the evolution of tail risk measures, as well as research on tail dependency. We also document a number of academic studies that assess tail risk and tail dependency of hedge fund returns.
This paper focuses on two related topics: the tension between the fundamental premise of long-term investing and the post-crisis pressure to mitigate tail risks; and new approaches to asset allocation and the potential role of global macro strategies in institutional portfolios.
To really understand why these issues are increasingly coming to the fore, it is important to recall the sheer magnitude of losses suffered by sovereign wealth funds and other long-term investors at the peak of the recent financial crisis and to appreciate how shocked they were to see large double-digit percentage drops, not only in their own portfolios, but also in portfolios of institutions that many of them were looking to as potential role models, namely the likes of Yale and Harvard university endowments. Losses for many broadly diversified, multi-asset class portfolios ranged anywhere from 20% to 30% in the course of just a few months. In one of the better publicized cases, Norway’s sovereign fund lost more than 23%, or in dollar equivalent more than $96 billion, an amount that at the time constituted their entire accumulated investment returns since inception in 1996. Some of the longer standing sovereign wealth funds in Asia and the Middle East, which had long invested in a wide range of alternative asset classes such as private equity, real estate and hedge funds, are rumoured to have done even worse in that infamous year.
Not surprisingly, in the crisis post-mortem, sovereign investors have been asking some pretty tough questions: what went wrong with our asset allocation; we thought we had sufficient diversification, but being invested in a broad range of asset classes clearly failed to protect us at precisely the time when it mattered most. In other words, the tail events of 2008 proved to be as unexpected as they were painful. If diversification didn’t work, what can long-term investors do to protect their portfolios going forward?
The global financial crisis (GFC) of 2007-08 was remarkably severe not only in the magnitude of drawdowns suffered by individual asset classes, but also thedrawdowns of portfolios thought to be well diversified. The risk of such an outcome has come to be labeled tail risk in reference to the extreme left tail of an asset’s or portfolio's return distribution. Since the GFC, many investment organizations have launched tail risk protection strategies designed to address such periods of severe market distress. Likewise, flows intomanaged futures strategies (commonly thought to profit during periods of elevated volatility) increased dramatically.
Tail risk represents the loss at the most negative part of an asset or portfolio’s return distribution, or the left tail. Many studies show that equity market returns do not follow a normal distribution, with tails fatter than predicted (Fama (1965)). Extreme losses occur during times of crisis or financial market distress. In these times, we observe a contagion effect marked by a pronounced rise in many asset class correlations to equities. Since it stands out as the dominant explanatory risk factor in multi-asset class portfolios, equity return is used as a proxy for financial market risk in our study. While protection against tail risk has generated considerable attention and asset flows, there is significant disagreement regarding the efficacy of such strategies and their cost/benefit tradeoffs. Theoretically, a tail risk strategy should have a low required rate of return because it pays off at times of market distress.
This paper measures the benefits and costs of several candidate tail risk protection strategies empirically using more than 20 years of monthly data from U.S. markets. We analyze four methods for controlling tail risk: (1) long volatility, (2) low volatility equity, (3) trend following, and (4) equity exposure management.
We consider an investment strategy to offer tail risk protection if it consistently outperforms equities when equity returns are most negative. We define portfolio tail risk as the conditional mean portfolio return in months where equity returns exceed a loss of five percent. For each tail risk strategy, we estimate the fixed allocation, that when combined with an equity portfolio, reduces tail risk by a constant proportion. In this way each tail risk strategy is compared on an equal footing based on its contribution to tail risk reduction. This paper also introduces two new measures of tail risk protection efficacy. First, we measure the cost of the protection in terms of annual performance drag when added to an equity portfolio. Then, we measure the certainty, or consistency, of the tail risk protection. The ideal tail risk strategy combines a low performance drag with a high certainty of protection. We identify a number of tail risk strategies that perform well along these two measures.
Equity market volatility in the past decade has at times reached levels not seen since the Great Depression. We forecast that risk will continue to be elevated for several years to come, as economic and market uncertainty persist. Some clients have limited ability to absorb further capital losses of the magnitude experienced in 2008-09.
The primary lever clients have to reduce total portfolio risk is a shift from return-seeking (equity, risky fixed income and alternative assets) to risk-reducing (fixed income) assets. But historically low fixed-income yields mean bond allocations won’t likely contribute much toward total portfolio return objectives, while at the same time they carry risk in terms of falling bond prices when rates rise. Investors want a way to reduce risk, especially the risk of large losses in tail events, but without giving up much return. At the same time, some investors have dampened enthusiasm for traditional active management to improve on capitalization-weighted indexes in terms of either value added or downside risk protection.
Consequently, a host of products advertised to reduce risk, without reducing return, have appeared since 2008. We’ll discuss several potential strategies for limiting risk, including low volatility equity strategies, tail risk products, and managed futures and global macro hedge fund strategies.