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Aon Retirement and Investment Blog

Comparing Risk Parity strategies: How to Benchmark Returns when Returns are Not Targeted

Risk Parity is a long-only systematic approach to multi-asset investing that focuses on targeting a certain level of volatility. In its most simple implementation, it builds portfolios that have equal risk exposures to the different asset classes without explicitly focusing on an absolute (or relative) return target[1].

The primary drivers of performance for a Risk Parity manager are the underlying asset class returns (e.g. traditional risk premia[2]) and the portfolio construction rules. Strategy implementation can differ significantly depending on a manager’s take on Risk Parity, which leads to a broadly diverse universe.

For example, the preferred asset mix is often not homogeneous across managers. Global equities, developed market bonds, and commodities are core parts of most Risk Parity portfolios, but some managers expand this range to include allocations to credit, liquid property and emerging markets. Notably, and somewhat contrary to what the term Risk Parity implies, some managers also deviate from allocating risk equally across assets, and tilt portfolio weights based on fundamental or technical considerations.

Appreciating the main traits of a specific Risk Parity implementation is key to assessing the performance of a manager. Some structural factors may favour one approach over another in shorter timeframes, and it is not uncommon to see rotation amongst the best performers.
Over time, however, these strategies are expected to perform in a similar manner, as the main traits they share (e.g. these are long-only multi-asset strategies) overcome the differences in implementation which impact short-term relative results.

So how should investors benchmark Risk Parity?

It depends on the scope of the comparison.

Being a growth allocation, Risk Parity is often benchmarked to a Balanced Growth Portfolio comprising 60% Global Equities and 40% Global Bonds[3] or other bespoke combinations of market indices. We find this comparison particularly useful for measuring the benefits of diversification that come from using a Risk Parity approach over the longer term but note that a relatively high tracking error should be expected over shorter timeframes.

Looking at benchmarking from a different perspective are the HFR Risk Parity Indices. These indices offer a good representation of the peer group (they are composed as an average of several managers’ returns), thus making it easier to assess the performance of one Risk Parity approach vs. a collection of others which target the same level of risk. Tracking error to a specific Risk Parity strategy is still expected to be meaningful, but markedly lower than the one calculated against market indices.

Over shorter timeframes, the deviations between these two comparators are expected to be high (see the chart below). However, over the long run there is an affinity in risk profile, and we argue that both provide useful information when assessing a Risk Parity strategy.

Finally, when approaching the proposition, some investors may be tempted to compare Risk Parity performance to the expected return that is often guided by the managers themselves. With this respect, we note that measuring a long-only multi-asset growth propositions against a "cash +" benchmark is not appropriate over shorter timeframes, while remaining a sensible approach for setting expectations over the very long run.

In summary
Risk Parity is a long-only multi-asset investment approach that has the distinctive feature of targeting volatility as opposed to expected returns.

We argue that this makes benchmarking Risk Parity managers’ performance more difficult, and that investors should investigate the main traits of the approach that has been selected before drawing conclusions.

Investors looking to compare Risk Parity to ‘similarly risky’ multi-asset allocations could use a bespoke combination of market indices that is representative of a growth allocation (we suggest here the Balanced Growth Portfolio for comparing Risk Parity strategies running at 10% volatility). The main drawback of using this approach in isolation is the expected high tracking error over shorter timeframes. On the other hand, investors looking to compare a Risk Parity manager to other investable Risk-Parity offerings have an industry recognized index which provides this very metric.
Riccardo Lawi is a hedge fund researcher within the Liquid Alternatives manager research division of Aon in London.
Click here for index descriptions.

“Content prepared for U.S. subscribers, but available to interested subscribers of other regions.”

[1] Typically, Risk Parity managers guide investor expectations on a long-term Sharpe Ratio (excess return per unit of volatility) between 0.5 and 0.7. Relative to more traditional active multi-asset propositions, the focus for Risk Parity shifts from maximizing expected returns to risk targeting.
[2] In this, Risk Parity differs from Alternative Risk Premia, whereas strategies want to take advantage of market inefficiencies through long/short positions. More information on Alternative Risk Premia can be found here
[3] Over long timeframes the Balanced Growth Portfolio has realized a volatility of approximately 10%, which is the risk level targeted by most flagship versions of Risk Parity strategies.

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