The role of leverage in risk parity is often misunderstood. 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.
The risk parity-versus-60/40 argument has always been about strategic long term — not tactical short term — asset allocation. Here I argue that, when viewed strategically, the empirical work on risk parity, including some of our own, understates its potential advantages. Moreover, all you need is basic finance theory to see it.
My colleagues have written a response to Thomas Hoenig’s recent WSJ op-ed “Why ‘Risk-Based’ Capital Is Far Too Risky.” Hoenig’s recommended approach to managing leverage risk using a “simple” notional leverage limit reminds us of Einstein’s famous purported comment to make things as simple as possible, but not simpler. The authors believe that Hoenig’s approach fails to meet the Einstein test. My colleagues explain why in their letter.
As always, I hope that you will share your feedback.
Recent reports claim that risk parity investors sold large amounts of equities during the most volatile times in August, contributing to — or even causing — share-price gyrations. In fact, risk parity sellers are not big enough to be significant players in the market correction.
In its normal form the small firm effect is, on a host of dimensions, weak to possibly nonexistent. Once adjusted for quality exposure it is real and spectacular.