Edward Qian, CIO of PanAgora Asset Management, coined the term “risk parity”, but he says there are misconceptions about how the approach uses leverage which, if used incorrectly, undermines its essence – risk diversification.
Qian, who is chief investment officer of macro-strategies and head of macro research for the firm, says the concept of risk parity, first and foremost, is diversification and to manage how risk is controlled.
“For too long investors have let markets dictate that,” he says, “whether it’s been through cap-weighted indices and the risks in 60:40 portfolios dominated by equity risk. Portfolios dominated by equities investors have been hit by multiple directions.”
While investors have relied on the equity risk premium as a return driver, the risk parity approach, Qian says, dictates there are other return drivers if an investor wants to innovate.
“With high-quality bonds, for example, they are low-return and low-risk but if you invest a large enough amount it looks as attractive as equities.”
The risk parity approach, which allocates capital according to risk not return, results in more of a balance of risk with the result that equity allocations are reduced, bonds are increased and futures are used to increase the notional exposure.
“It’s important to note this doesn’t mean using financial leverage but economic leverage,” Qian says. “There is a misconception that risk parity leverages a bond portfolio. The first thing is to build a robust portfolio then use leverage on the entire portfolio, not just the bond portion. It is a good way to use financial engineering, it’s not obscure. Investors shouldn’t be afraid of leverage if it is used the right way.”
While Qian’s paper, “On the Financial Interpretation of Risk: Risk Budgets do add up”, became a cornerstone for what is commonly referred to as ‘risk parity’, Bridgewater was using the techniques many years before in its All Weather portfolio, and AQR, now, has a great deal of assets managed in a similar manner.
“Bridgewater have been around for a long time, but we were the first to have a quantitative framework for risk allocation,” he says. “It is diversification at every level possible. Diversification is the only free lunch in investing, but people have forgotten about the free lunch and go for the fancy dinner and a very expensive bill.”
In PanAgora’s approach it looks at risk parity on a top-down level but also on every underlying asset class and investment, right down to the bottom-up stock level. Its global risk parity product has nine underlying asset classes and each one of those is an individual risk parity product as well.
The fund also has a dynamic component, rebalancing every month. At the moment it is neutral between equities and fixed income, although slightly overweight commodities against its long-term target.
Qian acknowledges how a name can become a trend, and is cautious of using the word “risk” in naming a strategy, but says it is satisfying to have his research accepted in the market place.
“We like to apply the latest thinking and research to investors’ portfolios. The research is done by the investment managers themselves not a separate research department, so can get ideas into the portfolio quickly. The typical quant firm is lagging behind in research, but you have to be ahead and have a structure to be able to apply it.”
Qian says the firm will continue to focus on the application of risk parity and to provide the best beta and superior alpha.
https://content.putnam.com/panagora/pdf/risk_party_portfolios.pdf
