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.
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.
Critics seeking to attack risk parity don't have to go all tin-foil-hat crazy — blaming the strategy for the exceptional market volatility last summer. Instead, they could just do what people usually do, attack recent performance, because risk parity has undeniably been through a tough relative performance period of late. But we still believe in it as an alternative long-term strategic asset allocation that’s typically used to diversify a more traditional equity-dominated allocation.
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.
Modestly levering a better, more diversified portfolio may improve upon an unlevered, much less diversified one; it is a rather sensible approach that is consistent with finance theory.
Many of the current articles that are critical of hedge funds may be giving good advice, but for the wrong reasons.
A buzzword in the investment community these days is active share, a specific way to measure how different a portfolio is from its benchmark; some proponents claim it predicts higher excess returns. Does it? No, as we show in a new AQR white paper.