“Factor risk parity enables the investors to look at risk premia independently of each other and to build portfolios that are better diversified and more efficient than a traditional risk parity approach,” says Sweeting. “The forecast hedge uses the insights from risk parity, which lead to automatically diversified portfolios, but adds a controlled layer of subjectivity. This allows investors to allow for strong views on the return prospects for particular asset classes.”
Meanwhile, Blackrock’s new risk parity version places a greater emphasis on integrating sophisticated “risk conditioners” which aim to reduce risk and de-lever the portfolio during periods of heightened market volatility. It also means incorporating an element of fundamental analysis which analyses how risk premia of different asset classes vary through time. This enables managers to adjust exposures to asset classes which exhibit extreme deviation from fair value.
“We call this risk parity 2.0 because it focuses on risk factors or the common return drivers,” says Rita Gemelou, investment strategist at Blackrock. “This allows us to build a more diversified portfolio which offers better protection in extreme environments. We look under the bonnet to see which factors – credit, macro-economic, liquidity, inflation, real rates and political risks – are impacting asset classes. In translation, this means a portfolio that holds, for example, developed and emerging market equities, fixed income including high yield, emerging market debt, corporate and government securities as well as property and commodities.”
Whatever risk parity is taken, Dan Greene, head of global consultant relations at Invesco, believes an active style is needed. “Passive risk parity products are popular with certain clients but I would not recommend it. Some assets fall more than others as witnessed by the recent sell-off which is why I would not just look at historical volatility. We focus on good ideas that are uncorrelated and invest in global equities, global bonds and certain commodities because they offer a good risk-reward trade-off.”
Other asset managers such as Natixis Global Asset Management believe in adopting a wider horizon. Eighteen months ago, the group launched its durable portfolio construction philosophy, which prompts investors to consider better use of asset classes and risk management tools and is supported by an online research centre, a portfolio construction tool and access to the firm’s portfolio research and consulting group.
“One of the main criticisms of risk parity is that it may be too naïve if all the factors are not taken into consideration,” according to Terry Mellish, head of UK/Ireland business and global consultant relationships for the French-based firm. “The aim of our new philosophy is that it makes better use of traditional asset classes as well as alternatives to mitigate risk and enhance returns.”
Pimco, on the other hand, favours a risk factor- based approach, which is driven by the underlying risk factors within various asset classes. This requires among other things a forward-looking macro-economic view on a variety of topics such as monetary policy, geopolitical developments, inflation, interest rates, currencies and economic growth trends. Asset classes are chosen that enable investors to gain exposure to these particular factors in the most efficient way. For example, if they wanted to have a non US dollar currency risk in their portfolio, a direct investment in currencies would do the trick but so too would foreign equities, bonds or even commodities.
“This approach gives you a robust framework for investing in a broad spectrum of asset classes,” says Jeroen van Bezooijen, product manager at Pimco. “This is not only the traditional equity strategies such as developed or emerging market equities but also fundamental, smart beta equity strategies. We also include government, covered and high yield bonds as well as bank loans plus alternatives which are not always easy to model because there is less market data available. However, we have the ability to model a wide range of investments ranging from private equity to real estate and different hedge fund strategies.”
A multi-faceted approach
There is of course no magic bullet for all investors, according to Wai Lee, chief investment officer of quantitative investment at Neuberger Berman. “With the special case of risk parity being arguably the most popular version, the risk-based approach is very broad with some investors looking at risk factors beyond just assets. Risk though can be multi-dimensional including volatility and tail risks among others, and we construct a portfolio according to a client’s specific investment goals, time horizons and drawdown tolerance.
“We discuss the various risk management approaches they can take but the most important components are flexibility and dynamism. You cannot for example, have a buy and hold static risk parity portfolio, because risks of assets change over time. For example, adjustments had to be made after the Japanese government and the Federal Reserve made their announcements about quantitative easing.
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