Does a perfect policy portfolio exist?

Jeffrey Knight, CFA, Global Head of Investment Solutions and Asset Allocation | May 5, 2014

  • Risk Parity represents a significant advance in asset allocation, but we don’t believe that there is a single perfect policy portfolio.
  • While Risk Parity works well in neutral markets, we don’t think it is the best policy under bearish, bullish or highly bullish market conditions.
  • We believe that a policy function that rotates among four distinct policy portfolios is closer to perfect than any single policy portfolio.

The idea of a policy portfolio, the core strategic asset class weightings for an investment portfolio, has evolved significantly during the course of my career as an asset allocation specialist. From the humble beginnings of standard balanced investing (the good old 60/40), investors have searched for the best neutral asset allocation to serve their goals over the long term. Over the last 20 years, we have seen these portfolios broaden as new asset classes are defined (like emerging market equity), or embraced as compatible with mainstream investing (like alternative investments). Not only have the components of strategic portfolios changed, but the methodologies for gaining exposure and determining asset class weightings have also advanced.

One of the most significant advances in the search for the perfect policy portfolio has been the investment strategy commonly known as Risk Parity. Risk Parity is an asset allocation approach that seeks to balance portfolio risk sensitivity to various asset categories evenly. The goal of Risk Parity is to eliminate the dominance of any single asset class, like equities, over the performance outcomes of the portfolio as a whole. To accomplish this, allocations to asset classes are measured by “risk contribution” as opposed to simply measuring the proportion of capital invested in each asset class. Intuitively, Risk Parity strategies extract a greater diversification benefit than portfolios that are unbalanced in their risk allocations. For the most part, the theoretical benefits of these strategies have been realized in the real world, as investors who have been willing to invest this way have generally enjoyed higher risk-adjusted returns and lower drawdowns than traditional 60/40 portfolios. Some managers even tout Risk Parity as the one true policy portfolio that can withstand any market conditions. So is it the perfect policy portfolio?

We don’t think so.

Risk Parity has contributed two breakthrough ideas to the practice of asset allocation. The first is the technique of measuring risk allocation as opposed to capital allocation. For example, a portfolio with 60% of its assets in equities and 40% of its assets in bonds might seem balanced, but in risk allocation terms it is anything but balanced. In fact, roughly 90% of the ups and downs of such a portfolio can be traced to the stocks, with bonds contributing a mere 10% of the volatility. Just by measuring the risk contributions, we can gain awareness of concentrations like this that asset weightings alone would never reveal. So enlightened, we can diminish unwanted risk concentrations and improve diversification. The second breakthrough is more controversial; namely, Risk Parity strategies utilize financial leverage. The typical Risk Parity portfolio owns about twice the market exposure of its cash on hand, so is leveraged about 2:1. The leverage enables risk balance without risk reduction. Without leverage, asset weightings to volatile assets would need to shrink, while investments in lower volatility assets would rise until the risk contributions even out. The resulting portfolio, though, would be much lower risk, and likely lower expected return, than the starting portfolio. Enter leverage. The leverage enables the manger to dial the overall portfolio risk back up, typically so that it is on par with something like a 60/40.

The idea of parity, however, is problematic. The argument for equalizing risk allocations across asset classes (or investment “buckets,” or whatever) contends that each component offers an identical prospective risk-adjusted return, and that investors are unable to differentiate among prospective opportunities. Ever. In this case, the risk allocation that maximizes risk-adjusted returns at the whole portfolio level would indeed be parity.

Looking forward, we think a case can be made that asset classes today do not offer identical prospective risk-adjusted returns. Critics of Risk Parity point out that the idea of using leverage to buy bonds when interest rates are as low as they are today makes no sense. They have a point. Formally speaking, these critics are positing that today’s markets are an exception to the benign conditions that support Risk Parity investing. It is this idea of exceptions that intrigues us. Perhaps Risk Parity is as close to a perfect policy portfolio as we can get, except for when it isn’t.

The Columbia Management Global Asset Allocation team has spent the last year researching whether exceptions to the Risk Parity assumptions can be identified in a systematic way. Our findings are as encouraging as they are straightforward. To wit, if bond yields are too low (we have a precise measurement for this, of course) then risk allocations ought to skew away from interest rate exposure. If equities are especially attractive (in risk-adjusted expected return terms), then risk allocations should skew towards equities. The diagram below depicts our simple framework for classifying market conditions using these concepts. This matrix maps four distinct combinations of major market conditions that are discernible in real time.

Knight1

The investment implication of this research is, we think, that there is no single perfect policy portfolio. Risk Parity style investing works very well in the upper left quadrant, which we consider neutral market conditions. Risk Parity, though, is not the best policy in the other quadrants, either intuitively or empirically. Moving clockwise from the upper left quadrant, we might suggest that conceptually appropriate policy portfolios could be, crudely speaking, Risk Parity (upper left), 60/40, (upper right), all equity (lower right), and capital preservation (lower left). In other words, we think that a policy function that rotates among four distinct policy portfolios corresponding to each quadrant is closer to perfect than any single policy portfolio.

This distinction matters today, we think. An extended episode of extreme monetary easing has created very low bond yields worldwide and has wrought an intentional inflation in risky assets of all kinds, from stocks to real estate. At some point (not yet) investors will be faced with the challenge of protecting their portfolio gains that have accrued through this episode. Will bonds and leverage be the perfect combination that accomplishes the desired portfolio protection? Traditional Risk Parity investors will find out.