Improving on Risk Parity

October 28, 2012

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In this issue we include research from JP Morgan Asset Management.  They have a few new pieces out on the topic of risk parity.    The author’s introduction is below:

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So far, the twenty-first century has not been much fun for institutional investors. U.S. equities underperformed not only expectations, but fixed income as well, calling into question the 60/40 split between equities and bonds that has become the baseline for strategic asset allocation. In this harsh environment, the Risk Parity approach to strategic investing has flourished, not only because its leveraged fixed income exposure has produced high returns, but also because it advances a novel investment principle: The key to asset allocation is to allocate equal shares of portfolio risk to each asset class.

The important question for investors is whether Risk Parity will work as well in the future. This is more a matter of the investment principles it involves than whether bonds will continue to outperform stocks. The goal of the research project described in the following pages is to understand and evaluate these investment principles and ultimately to incorporate their positive contribution into an improved approach to strategic asset allocation.

Our answer is somewhat surprising. We demonstrate that equal risk shares is meaningless as a guide to investment choices. Instead, we focus on a particular consequence of following the equal risk shares principle: that portfolio choices pay no attention to forecasts of asset class returns. Why might this be a good thing? To the extent that you are sure that the average return on stocks is going to be equal to your 8% forecast, it would not seem wise to ignore it. But if you are uncertain, you should probably tone down your reliance on the forecast, and if you are very uncertain, you could be better off ignoring the forecast altogether, which is what risk parity does.

Plainly, we are uncertain about forecasts and would do well to factor this uncertainty into asset allocation decisions. The Forecast Hedge asset allocation rule that we propose strikes a balance between the conventional approach to asset allocation (ignore the uncertainty) and risk parity (ignore the forecasts), by measuring the amount of uncertainty and weighting the two accordingly. In our tests across a wide range of return environments, the Forecast Hedge outperforms the two extremes.

Here, as elsewhere, there is no free lunch. To use the Forecast Hedge, you need to supply a measure of the confidence or uncertainty you attach to your return forecasts. This is extra work and it may be difficult to do this precisely, but these are not reasons to avoid trying. After all, if you are uncertain about your forecast uncertainty, how can you be certain about your forecast? Moreover, our analysis suggests that precision is not crucial and that the benefits of taking a position on uncertainty can be substantial.

We hope these ideas will help make strategic asset allocation more practical, and as always, welcome your thoughts and comments.

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Here are their white papers:

Improving on Risk Parity (Summary version)

and some related videos of mine:

For more information:

The Strategy Group partners with clients to develop objective, thoughtful solutions to the broad investment policy issues faced by corporate and public defined benefit pension plans, insurance companies, endowments and foundations. Our global team is one of J.P. Morgan Asset Management’s primary centers of investment insight and innovation as well as advisory services for institutional clients in the areas of asset allocation, pension finance and risk management.

Peter Rappoport

Managing Director

Global Head, Strategy Group

Nicholas Nottebohm

Analyst

Strategy Group

For more than a century, institutional investors have turned to J.P. Morgan Asset Management to skillfully manage their investment assets. This legacy of trusted partnership has been built on a promise to put client interests ahead of our own, to generate original insight and to translate that insight into results.

Today, our advice, insight and intellectual capital drive a growing array of innovative strategies that span U.S., international and global opportunities in equity, fixed income, real estate, private equity, hedge funds, infrastructure and asset allocation.

This publication was edited, designed and produced by the Institutional Americas marketing group at J.P. Morgan Asset Management.