The hidden risks of risk parity portfolios

The benefits of risk parity portfolios are largely an illusion and contain hidden risks such as confusing volatility with risk and including asset classes that have significant negative skew, which combined with leverage could be painful for investors, according to director of asset allocation at GMO, Ben Inker.

In a recent GMO paper, that in part responds to the recent spate of positive papers on the risk parity approach, Inker says by shifting to risk parity portfolios now, investors run the risk of loading up on fixed income duration after the best run for bonds in history, a run that has left government bonds, in the opinion of GMO, looking extremely dangerously overpriced.

“But apart from the tactical question of whether to move to risk parity now, we believe more generally that the benefits that risk parity portfolios offer are largely an illusion,” he says.

“No particular fixed weight benchmark is a good solution for all time or all environments. Risk parity portfolios are no exception.”

In the paper he says there are three basic weaknesses in risk parity portfolios.

Firstly, they suffer from the same basic flaws as value-at-risk and other modern portfolio theory tools – they confuse volatility with risk, assuming that if the standard deviation of the portfolio over some particular time period is x per cent, that is really all the investor needs to know.

Secondly, the paper says, some of the asset classes generally included in these portfolios have risk premiums that may well be zero or negative for the foreseeable future.

And third, several of the asset classes involved in these portfolios have significant negative skew, which makes the backtests behind them suspect and, in conjunction with the leverage, may prove extremely painful to investors.

He says leverage adds an element of path dependency to investors.

“An unlevered investor can generally wait for prices to converge toward economic reality, but a levered investor may not have that luxury. A number of proponents of risk parity portfolios point that stocks are inherently levered investment because the average company has a debt/equity ratio of approximately 1:1. What makes that sort of leverage acceptable while the other is not? To our minds, one very large difference between the two is that the leverage companies acquire is long term and not marked to market.”

The paper says another problem for risk parity portfolios is that the risks that investors are leveraging may not actually have a positive return associated with them.

“We believe that several asset classes usually included in risk parity portfolios may well have negative risk premiums associated with them, either because of the pricing prevailing in the asset class today, or the general features of the asset class.”

He examines commodities and government bonds as examples of assets whose risk premium may prove negative for an inconveniently long time.

For GMO registered users the paper can be accessed here