The role of leverage in risk parity is often misunderstood. All else equal, more leverage increases both risk and expected return. But all else is not equal here. The willingness to use modest leverage allows a risk parity investor to build a more diversified, more balanced, higher-return-for-the-risk-taken portfolio. In our view, this more than compensates risk parity investors for the necessity of employing some leverage. Let’s first step back and consider the basics.
We believe that to be called a risk parity strategy there are two crucial ingredients:
In 1, no agreement on how to measure risk is necessary for different investors to rightly claim to be doing risk parity (just like different investors legitimately pursuing “value” investing won’t share the precise same methodology or current views). One investor can believe risk is best approximated by estimates of volatility, another by more left tail sensitive measures. One investor can be purely quantitative when assessing risk, another can apply any degree of subjective judgment. One investor can vary their risk estimates through time, while another can eschew short-term estimates. All can fall under “risk parity” — except the investors who think of balance and diversification, as is so often the case, only by dollar allocation. By doing this, they ignore, literally or effectively, the fact that if you put half your money in an asset that’s much riskier than the other half, you are not a risk-balanced investor (i.e., you ain’t “50/50”).
In 2, leverage is used only after deciding on the best unlevered portfolio. This is not some newfangled idea. Rather, it’s among the earliest and most established ideas in finance. If you have a view on what’s the best risk-adjusted return portfolio and you desire more return, there are only two ways to get there at the asset class level: you can sell low-risk to buy high-risk assets; or you can lever the best unleveraged portfolio. Basic theory favors the latter, which retains the best portfolio, while the former moves away from it. In other words, to get more expected return without leverage you must get less diversified and more concentrated in the riskier asset classes.
The best unlevered portfolio tends to differ systematically from traditional portfolios. The risk parity portfolio almost always has more weight in lower-risk assets (like bonds) and better diversifiers (like commodities, which may be risky viewed alone but don’t add as much risk in a portfolio context); and less weight in the aggressive assets that drive conventional portfolios, namely equities. In other work we have discussed why we believe more risk balanced allocations are superior (see Asness, Frazzini and Pedersen, “Leverage Aversion and Risk Parity”) with lower risk assets having higher risk-adjusted returns than they “should” have. Ironically, we believe that much of risk parity’s benefit arises precisely because investors overly fear the leverage we discuss here (or simply cannot undertake it). Moreover, this same observation, that lower risk assets have higher Sharpe ratios than simple theory says they should, shows up not just across asset classes as we discuss here, but within asset class after asset class (see Frazzini and Pedersen, “Betting Against Beta”), most famously seen within stocks as the “low-beta” anomaly. While “better balance” is a great way to think about risk parity, it’s actually not enough to believe in it. You need a reason why concentrating in equities, the asset that still dominates market-capitalization-weighted portfolios, is not better rewarded (or equivalently why low-risk assets are rewarded more than simple theory would suggest). We believe leverage aversion is just such a reason — simple, intuitive, and strongly supported by long-term data, in- and out-of-sample, from a wide variety of investments.
Putting it starkly, if you start with your opinion of the best risk-adjusted unlevered portfolio you can create, but believe that its expected return is just too low, you have two choices. Both are forms of risk. Nobody should tell you otherwise. One choice is take on the risks that come with leveraging that portfolio. The other choice is to take on the risk of concentration — in this case, most often concentration in the riskiest asset, namely equities. The first is the risk chosen by investors preferring risk parity. The second is the risk investors in traditional portfolios often take, perhaps without consciously choosing to do so.
We do not think leverage is riskless. Run screaming from anyone who believes that. We simply believe, in moderation, leverage is a better risk to take in pursuit of higher returns than is the risk of concentration. Moreover, basic economics says that for the same risk taken, leveraging the best unlevered portfolio should gain you extra return versus concentrating in the best single asset class. In other words, both leverage and concentration are risks, but we believe leverage is more manageable than concentration, and you get rewarded for it with a higher expected return. There is little you can do to manage concentration risk, save pray it doesn’t kill you.
Even radical efficient marketers accept that leveraging the best portfolio is the way to go (though they’d probably prefer to lever a capitalization-weighted portfolio) if more expected return is needed and more risk acceptable. The power of diversification — given up by those who chose concentration, but harnessed by those who lever their best portfolio — is close to the only thing generally agreed upon in finance. Taking risks is what long-term investors do, and again, leverage is a risk. However, taking unmanageable poorly rewarded risks, like long-term concentration in one risky asset class, is not a good idea for anyone.
Now, let’s talk about some specifics regarding leverage that often come up in discussions:
Note that “CAL” stands for “capital asset line” and more discussion of this is not necessary here (though we love to talk about it long into the evening if you’re ever up for it).
Even if one does not believe, as we do, that the “best” portfolio is more balanced than traditional allocations, this logic still applies. We believe an investor would, for instance, be better off applying mild (in this case very mild) leverage to the traditional 60/40 portfolio rather than moving to all equities (in fact, we’ve been making this argument for quite a while now — see Why Not 100% Equities). Again, risk parity is not a theoretical exercise. Rather, it’s about expecting to end up with more money!
There are no guarantees, and that of course applies to risk parity, and any strategy, over even the long-term. We believe it offers a modest but real long-term edge versus traditional approaches and that it is diversifying, and we do not believe current times are an actionable exception to this long-term truth. But, we try not to overstate our case. A “modest” edge means risk parity can have long tough periods in both absolute (sometimes all investments stink) and relative (to equities or equity dominated portfolios) terms. Having said that, again, that goes both ways, as the same is true for traditional allocations. Unless you can time the market with great precision or have very low return goals that allow you the luxury of taking very little risk, you must face long tough periods whatever you do.
Remember, saying things like “rates will someday go up a lot” is not enough to predict that risk parity will underperform. To predict this, you must correctly forecast a sharp jump in rates soon that also doesn’t overly hurt stocks or help commodities. That scenario is possible, of course, but it’s only one of many possibilities, including the possibility that not much changes in the near future. Unless you can make specific, accurate forecasts that include getting the timing right (that is the aspect most often forgotten) we do not think you can overcome the long-term advantages of better diversification made possible by using leverage to balance the asset classes and to achieve desired expected returns, the basics of risk parity. There is no riskless way to achieve your goals through asset allocation, specifically a return goal that is above that offered by low risk assets. You can concentrate in the higher risk/return asset, usually equities, as is so common, or you can use risk parity and some modest leverage to spread your bets more widely and get there, we believe, with more long-term reliability.
We understand there is a comfort to concentrating in equities. When you lose a lot of money, you have a lot of company, and plenty of experts to say it isn’t your fault. When risk parity underperforms — and we certainly aren’t predicting this for any particular time, either because equities soar or bonds or commodities crash — you’ll have only us and a few loyal friends who still like you even when you’re (short-term, ex post) wrong. But we believe the drug of equity concentration and the comfort and conformity it brings is purchased at the expense of long-term portfolio health.
Leverage is a tool. Hidden leverage, unmanaged leverage, excessive leverage and insecure leverage have all sunk many ships. But if used with moderation and care to balance and diversify, not just amplify, and thus build a better portfolio, we believe, and basic financial theory teaches, it is long-term prudent not scary.
P.S. There are of course arguments back and forth about risk-parity that are not focused primarily on leverage. This is not the place to go into them in any depth, but just to mention two we’ve heard recently:
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