Investors Can Develop An “All Weather” Risk Parity Portfolio That Will Outperform

https://www.youtube.com/watch?v=pEX-UlEfEBU?start=1799

In his recent interview with Tobias, Adam Butler, CIO of ReSolve Asset Management discusses how investors can develop an “all weather” risk parity portfolio that will outperform. Here’s an excerpt from the interview:

Adam Butler: So, that sort of understanding crystallized over several years. It wasn’t sort of an overnight epiphany, but as we started to learn more about the precepts of risk parity and the all weather concept and what drives asset pricing, then this whole idea took shape. But the initial focus was on asset allocation because that was where we discovered that if you were properly diversified, you least susceptible to the vagaries of just being in the market at the wrong time.

Tobias Carlisle: So, just to talk to us a little bit about risk parity. You’re looking at as many asset classes as you possibly can, and you’re allocating to those asset classes based on … you’re trying to equilibrate the risk for each, defined as volatility in that sense.

Adam Butler: Yeah. Just at the highest level of abstraction, the idea is that assets are predominantly sensitive to two dynamics, and those are changes in inflation expectations and changes in growth expectations. So if you have an unexpected change in either expectations for growth or inflation, then that change will impact different asset classes in different ways for different reasons, right.

So you’ve got traditional kind of growth assets like equities and real estate, and sometimes commodities, but then equities do particularly well, especially sort of developed equities do particularly well during deflationary growth environments, whereas commodity oriented economies or stock markets, like emerging markets, tend to do well in inflationary growth environments. Stagflation where you’ve got high inflation and low growth, you typically get really great performance in commodities and gold and tips.

Adam Butler: And then you’ve got deflationary bursts like the Great Depression in 2008 where you want to rely on things like long term treasury bonds, cash and gold, right? So, you don’t know what environment you are going to be going into next or be facing next, and so you just want to have access to all of these different asset classes that are fundamentally designed to do well and in each of these different quadrants.

So now that’s diversity, you want to have sufficient diversity, and then to your point, you also want to have balance. Because the problem is you’ve got emerging market bonds, and you’ve got intermediate treasuries, and so one of them is going up and down at one or 2% a day and the other is going up and down at a half percent a day, and so as you accumulate the returns over time for these different assets, the returns in emerging markets are going to completely swamp the returns to intermediate treasuries. So, the treasuries don’t have an opportunity to diversify the stocks.

Adam Butler: So, if you want all of these different asset classes to be able to diversify one another, then you’ve got to scale them to contribute the same amount of risk to the portfolio. And how you define risk and how you equalize risk is a whole very deep conversation. But at the highest level of abstraction, you just want diversity across all these different macro environments and you want balance across each of these different markets, and that gives you a risk parity.

Tobias Carlisle: And so the philosophy that you describe in your book, Adaptive Asset Allocation, that’s what you’re driving at and that’s what you’re trying to incorporate in the firm?

Adam Butler: Yeah, I mean, that’s sort of the place to start, which is you want to have access to a universe of assets where at least one of them will be positively exposed to whatever economic environment we are going to face in the future. So, that’s sort of step one, and we use risk parity to help to develop that universe. And then we describe the optimality conditions for risk parity, in other words, under what conditions about relationships between risk and return is the risk parity portfolio mean variance optimal?

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Investors Can Develop An “All Weather” Risk Parity Portfolio That Will Outperform

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