Will My Risk Parity Strategy Outperform?

Abstract

The authors gauged the return-generating potential of four investment strategies: value weighted, 60/40 fixed mix, and unlevered and levered risk parity. They report three main findings: (1) Even over periods lasting decades, the start and end dates of a backtest can have a material effect on results; (2) transaction costs can reverse ranking, especially if leverage is used; and (3) a statistically significant return premium does not guarantee outperformance over reasonable investment horizons.

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We examined the historical performance of four familiar investment strategies over an 85-year horizon. Our study included a market or value-weighted portfolio, which is the optimal risky portfolio in the capital asset pricing model, and a 60/40 mix, which is popular with pension funds and other long-horizon investors. Our study also included two risk parity strategies: one that is unlevered and another that is levered to match market volatility. Risk parity has been popular since the 2008 financial crisis, as frustrated investors have struggled to meet return targets by levering low-risk or low-beta assets or portfolios.

Our main findings are as follows.

Performance depends materially on the backtesting period. Our results are consistent with the notion that the relative performance of risk parity strategies is better in turbulent periods than in bull markets. This finding is plausible because turbulence is often accompanied by a flight to quality, when safer (low-risk) assets tend to increase in value. However, we do not have sufficient data to support the finding statistically.

Market frictions negate the outperformance of an idealized (frictionless) levered risk parity strategy. Our results are consistent with the empirical literature on the low-beta/low-risk anomaly. Specifically, in a frictionless setting, our low-risk strategy had higher risk-adjusted returns than our high-risk strategies. We extend the empirical literature by showing that this effect can persist after taking market frictions into account. However, leverage exacerbates market frictions, which degrade both return and risk-adjusted return. We further extend the literature by showing that after accounting for market frictions, a risk parity strategy levered to match market volatility underperforms the market on the basis of both return and risk-adjusted return. Specifically, among the four strategies we examined, unlevered risk parity had the highest Sharpe ratio and the lowest expected return over the 85-year period of our study (1926–2010). When the unlevered risk parity was levered to have the same volatility as the value-weighted portfolio, transaction costs reduced its Sharpe ratio and its cumulative return was less than the return of the 60/40 and value-weighted strategies. In summary, at least for the simple risk parity strategy we examined, market frictions fully explain the anomaly.

A statistically significant return premium is hard to come by, and in any case, it is far from a guarantee of outperformance over reasonable investment horizons. The confidence intervals on the returns of an investment strategy are very wide, even with many decades of data. Thus, it is rarely possible to demonstrate with conventional statistical significance that one strategy dominates another. However, even if we were reasonably confident that one strategy achieved higher expected returns than another without incurring extra risk, it would be entirely possible for the weaker strategy to outperform over periods of several decades, certainly beyond the investment horizon of most individuals and even perhaps of such institutions as pension funds and endowments.

We thank Bernd Scherer for careful reviews and insightful comments that improved this article; we also thank Günter Schwarz for educating us about the history of risk parity and for providing us with early references on the subject. We gratefully acknowledge the valuable feedback on our ideas and results from the participants in the Q Group Spring 2012 Seminar. Robert Anderson and Stephen Bianchi were supported by the Coleman Fung Chair in Risk Management at the University of California, Berkeley.