Managing risks is crucial, and risk parity looms large as one way to achieve it.
This article is part of a regular series of thought-leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Ted Mulrane, vice president and director of quantitative research for Boston Advisors LLC.
The financial crisis led investors to take a closer look at asset allocation techniques that emphasize the diversification of risk.
A number of approaches to portfolio construction that use "risk budgeting" have been proposed. The process of risk budgeting involves identifying how each asset in a portfolio contributes to the volatility of the total portfolio, and allocating these assets in a way to achieve a desired risk profile.
The goal is a portfolio that mitigates exposure to—in former Secretary of Defense Donald Rumsfeld's parlance—the "known unknowns" that are reflected in the volatility of and correlation between individual assets. It's important to note that allocation-based approaches to controlling risk do not explicitly address tail risk—the "unknown unknowns," that are best hedged against using options.
Risk budgeting approaches differ from the traditional Markowitz framework of mean-variance optimization by downplaying, or completely ignoring, return forecasts and focusing on the more stable risk characteristics of individual assets.
Risk parity is a particular risk budgeting approach where each asset in the portfolio contributes an equal amount of risk. One intuitive formulation defines risk contribution for asset "i" as: the weight of asset i in the portfolio multiplied by the volatility of asset I multiplied by the correlation between asset i and the portfolio.
Thus, assets that exhibit low volatility and low correlation to other assets receive more weight, and vice versa. To determine the asset weights, one needs to solve a nonlinear optimization problem. Here we use an iterative procedure where weights of the asset classes are varied until reaching an optimal solution that minimizes the sum of pairwise differences of risk contributions. (Please refer to the technical note at the end for more detail.)
To illustrate these ideas, we start by introducing a capital parity portfolio to illuminate historical risk levels associated with certain asset classes. Then, we present two methods for constructing a risk-parity portfolio using ETFs—unleveraged and leveraged. Lastly, we share our insights into risk parity and how we prefer to construct these portfolios at Boston Advisors.
As a point of background, our sample risk-parity portfolios use a global palette of asset classes, including equity, real estate, intermediate-term U.S. Treasurys, currencies (mimicking the carry trade) and commodities.
Risk contributions and performance statistics are computed based on monthly index returns over the period April 1994 to December 2013. The portfolios use ETFs that provide exposure to each of these asset classes:
| Asset Class | Index | ETF |
| US Equities | S&P 500 | SPY |
| Int'l Developed Equities | MSCI ACWI | EFA |
| Emerging Markets Equities | MSCI EM | VWO |
| Global Real Estate | DJ Global REIT | RWO |
| Agriculture | GSCI Agriculture | JJA |
| Energy | GSCI Energy | DBE |
| Precious Metals | GSCI Precious Metals | DBP |
| Currencies | DB G10 Currency Future Harvest Index | DBV |
| US Treasurys | Barclays U.S. 7-10 Year Treasury Bond Index | IEF, UST |
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