8 - Qian, Risk Parity · 2019. 2. 26. · The Myths and Facts of Risk Parity . ... » Private...

Discussion and Debate

Edward Qian, PhD, CFA

PanAgora Asset Management

The Myths and Facts of Risk Parity

Risk Parity in a nutshell

» Capture return premiums in a risk-balanced diversified portfolio

Risk Parity

Risk Parity

8%

Risk Parity Line and Traditional Frontier Bonds, 5%

1

60/40

25/75 Risk

Parity

Risk Parity

Line

Risk Parity

9.6%

1%

2%

3%

4%

5%

6%

7%

0% 5% 10% 15% 20%

Retu

rn

Risk

Stocks,

95%

Stocks,

50%

Bonds,

50%

Is Risk Parity dangerous?

» Leverage

» Liquidity risk

Discussion and Debate

2

» Risk premiums

Leverage – A Taboo after 2008?

» Modern economy is built on credit

» Banking system, corporate borrowing, consumer credit

» Businesses that own both insurance companies and investment

Leverage

3

» Businesses that own both insurance companies and investment companies – guess who?

» State governments that issues debts to invest in pensions – good idea?

» Investment strategies use leverages

» Private equity, real estate, hedge fund, common equity, 130/30

» Risk Parity

Leverage – good and bad

» Excessive leverage and illiquidity

» LTCM – 200:1 and spread trades

» Bear Stearns and Lehman Brothers: 30-40:1 and overnight repos versus

Leverage

4

» Bear Stearns and Lehman Brothers: 30-40:1 and overnight repos versus structured credits

» AIG: CDS insurance without capital reserve – it’s free money, ∞:1

» Good and prudent use of leverage

» Corporate issuers with strong balance sheet – why would Google do it?

» Risk Parity to both reduce risk concentration and enhance return » 2:1 Leverage is applied to the whole portfolio NOT just to bonds

» Cash 5 – 10 times of required collateral

Investing in illiquid assets

» Many alternative investments are highly illiquid

• Private equity, real estates, hedge fund

Don’t need quantitative measure for it

Liquidity

5

• Don’t need quantitative measure for it

• Multi-year lock-up

• Withdraw halted during 2008 financial crisis

» Traditional asset classes have varying degree of illiquidity

» Should risk parity invest in illiquid assets?

Correlation and liquidity/volatility

Liquidity

GSCI S&P 500 Russell 2000 MSCI x US EM Equity US Treasury US TIPS US Corp US MBS US ABS US CMBS US HY EMB Chg Tedsp Chg VIX

GSCI 1.00

S&P 500 0.22 1.00

Russell 2000 0.23 1.00 1.00

MSCI x US 0.24 0.82 0.82 1.00

EM Equity 0.31 0.72 0.73 0.77 1.00

US Treasury -0.04 -0.13 -0.14 -0.24 -0.20 1.00

US TIPS 0.26 0.02 0.03 -0.09 0.10 0.65 1.00

ABS/CMBS/HY/EMB 's

poor liquidity and equity

Diversification

against equity risk

6

US TIPS 0.26 0.02 0.03 -0.09 0.10 0.65 1.00

US Corp 0.14 0.27 0.27 0.20 0.24 0.68 0.67 1.00

US MBS -0.05 0.04 0.03 -0.08 -0.06 0.84 0.60 0.71 1.00

US ABS 0.22 0.12 0.13 0.06 0.13 0.42 0.60 0.69 0.54 1.00

US CMBS 0.20 0.31 0.32 0.23 0.33 0.22 0.49 0.55 0.22 0.44 1.00

US HY 0.23 0.60 0.61 0.57 0.61 -0.09 0.26 0.54 0.11 0.46 0.58 1.00

EMB 0.17 0.55 0.56 0.57 0.69 0.14 0.36 0.48 0.28 0.32 0.45 0.57 1.00

Chg Tedsp -0.12 -0.07 -0.10 -0.13 -0.19 0.06 -0.28 -0.29 0.03 -0.36 -0.41 -0.39 -0.22 1.00

Chg VIX -0.19 -0.69 -0.70 -0.65 -0.62 0.12 -0.10 -0.34 -0.02 -0.10 -0.29 -0.54 -0.61 0.21 1.00

poor liquidity and equity

exposure

» Monthly returns from 1993 to 2010

» Change in TED spread as a liquidity measure

» Change in VIX as a volatility measure

Risk, return and tail risks

Liquidity

GSCI S&P 500 Russell 2000 MSCI x US EM Equity US Treasury US TIPS US Corp US MBS US ABS US CMBS US HY EMB

Excess Return 0.74% 4.78% 4.94% 0.90% 6.46% 2.80% 3.39% 3.47% 3.00% 2.31% 3.60% 4.62% 8.21%

Volatility 29.08% 18.36% 18.55% 19.05% 30.65% 4.62% 4.99% 6.43% 3.20% 5.06% 11.43% 12.52% 12.69%

SR 0.03 0.26 0.27 0.05 0.21 0.61 0.68 0.54 0.94 0.46 0.31 0.37 0.65

Skewness -0.37 -0.73 -0.78 -0.79 -0.78 -0.21 -0.98 -0.70 -0.04 0.16 -0.82 -1.21 -2.40

7

Skewness -0.37 -0.73 -0.78 -0.79 -0.78 -0.21 -0.98 -0.70 -0.04 0.16 -0.82 -1.21 -2.40

Kurtosis 1.66 1.14 1.32 0.89 2.05 1.07 5.64 4.66 1.83 11.73 18.62 9.68 13.76

ABS/CMBS/HY/EMB 's

greater tail risks

High Sharpe ratios of

for bonds

» High-risk assets did not perform well, why?

» Low quality bonds fall between stocks and investment grade bonds and they

have a high degree of illiquidity and tail risk, ill-suited for risk parity

Some perspectives

» Is Sharpe ratio of 0.25 for equity low?

• Not really – between 0.2 to 0.3 over long time period

Equity Risk Premium

8

» Why it was not higher?

• Extremely favorable environments: declining inflation, global economic expansion, emerging market growth, Greenspan puts, etc.

• It is just volatile: value destruction from tech bubble and credit bubble

• Or maybe it’s cap-weighted indices

» It is very hard to forecast 45.0%15

%25.0%5%2=

−+=SR

Some perspectives

» Is Sharpe ratio of 0.60 high?

• Yes - between 0.2 to 0.3 over long time period

» Why it is so high?

Bond Risk Premium

9

• Disinflation in the US and in the developed world

• Without the tailwind of declining rates, it would be near 0.40

» It is very easy to forecast and the rates are going up because …

55.0%5

%25.0%3=

−=SR

05.0%5

%25.0%)5.0(6%3−=

−−=SR

15.1%5

%25.0%)5.0(6%3=

−+=SR

Relative return and relative valuation

» Stocks have higher expected returns than bonds, even in the “best”

scenario for bonds – they should!

» Stocks look so cheap relative to bonds

Stock versus Bond

10

» Stocks look so cheap relative to bonds

• Earning yield = 1/15 = 6.67% >> bond yield = 3%

» But stocks are riskier, they should be cheaper. What about risk-

adjusted valuation

• Earning yield/risk = 6.67/15 = 0.44; bond yield/risk = 3/5 =0.60

» How to beat a 60/40 benchmark, why not 70/30 - is that TAA?

Two contradicting views

» Commodities offers no risk premium

• Suppliers can always produce more to meet the demand

• No income, no dividend

Commodity Risk Premium

11

• Historical returns came from roll yield

» Commodities are in short supply

• The era of low price is over: emerging market demand

• Dwindling resources, peak oil

• Fiat currencies in trouble

Understand roll yield

» Investing in commodity futures

• Rolling into next contract

• Contango (negative roll yield) versus backwardation (positive roll yield)


12

• Contango (negative roll yield) versus backwardation (positive roll yield)

» Financial futures are often in contango (S&P 500, Treasury, gold)

due to spot-future parity

• Yet they have had long-term positive returns - buy high/sell higher?

» Why commodity futures depends on roll yields?

• Sell high/buy low?

Understand roll yield

» Roll yield is important only if the price of a commodity stays

unchanged for the long run


SP

13

1

2

BP1

SP1

BP2

SP2

1

2BP1

SP1

BP2

SP2

( )( )pricerollB

S

B

S

B

S

B

S

ryP

P

P

P

P

P

P

Pr ++=⋅

=⋅=+ 111

1

2

2

1

2

2

1

1

RollRoll

Roll yield

Historical prices


40

60

80

100

120

140

160

CL1 comdty

400

600

800

1000

1200

1400

1600

1800

GC1 Comdty

14

0

20

40

8/1/1986

3/1/1987

10/1/1987

5/1/1988

12/1/1988

7/1/1989

2/1/1990

9/1/1990

4/1/1991

11/1/1991

6/1/1992

1/1/1993

8/1/1993

3/1/1994

10/1/1994

5/1/1995

12/1/1995

7/1/1996

2/1/1997

9/1/1997

4/1/1998

11/1/1998

6/1/1999

1/1/2000

8/1/2000

3/1/2001

10/1/2001

5/1/2002

12/1/2002

7/1/2003

2/1/2004

9/1/2004

4/1/2005

11/1/2005

6/1/2006

1/1/2007

8/1/2007

3/1/2008

10/1/2008

5/1/2009

12/1/2009

7/1/2010

2/1/2011

0

50

100

150

200

250

300

350

400

450

500

HG1 Comdty

0

20

40

60

80

100

120

140

11/1/1986

6/1/1987

1/1/1988

8/1/1988

3/1/1989

10/1/1989

5/1/1990

12/1/1990

7/1/1991

2/1/1992

9/1/1992

4/1/1993

11/1/1993

6/1/1994

1/1/1995

8/1/1995

3/1/1996

10/1/1996

5/1/1997

12/1/1997

7/1/1998

2/1/1999

9/1/1999

4/1/2000

11/1/2000

6/1/2001

1/1/2002

8/1/2002

3/1/2003

10/1/2003

5/1/2004

12/1/2004

7/1/2005

2/1/2006

9/1/2006

4/1/2007

11/1/2007

6/1/2008

1/1/2009

8/1/2009

3/1/2010

10/1/2010

LC1 Comdty

0

200

400

600

800

1000

1200

1/1/1981

10/1/1981

7/1/1982

4/1/1983

1/1/1984

10/1/1984

7/1/1985

4/1/1986

1/1/1987

10/1/1987

7/1/1988

4/1/1989

1/1/1990

10/1/1990

7/1/1991

4/1/1992

1/1/1993

10/1/1993

7/1/1994

4/1/1995

1/1/1996

10/1/1996

7/1/1997

4/1/1998

1/1/1999

10/1/1999

7/1/2000

4/1/2001

1/1/2002

10/1/2002

7/1/2003

4/1/2004

1/1/2005

10/1/2005

7/1/2006

4/1/2007

1/1/2008

10/1/2008

7/1/2009

4/1/2010

1/1/2011

W 1 Comdty

0

200

400

1/1/1981

10/1/1981

7/1/1982

4/1/1983

1/1/1984

10/1/1984

7/1/1985

4/1/1986

1/1/1987

10/1/1987

7/1/1988

4/1/1989

1/1/1990

10/1/1990

7/1/1991

4/1/1992

1/1/1993

10/1/1993

7/1/1994

4/1/1995

1/1/1996

10/1/1996

7/1/1997

4/1/1998

1/1/1999

10/1/1999

7/1/2000

4/1/2001

1/1/2002

10/1/2002

7/1/2003

4/1/2004

1/1/2005

10/1/2005

7/1/2006

4/1/2007

1/1/2008

10/1/2008

7/1/2009

4/1/2010

1/1/2011

Capture risk premiums in a diversified portfolio

» Positive and roughly equal risk-adjusted premiums

» Forecasting long-term returns is challenging

Risk Parity and Risk Premiums

15

» Diversification is key to risk-adjusted returns

• Nominal bonds and commodities – a natural hedge

• Pro-growth risky assets versus counter-cyclical safe assets

• A Chinese fable – Spear and Shield

» No need for diversification with perfect foresight and certitude

Risk Parity as alternative investments

» Risk Parity focuses on risk-adjusted returns

» It has presented some challenges to traditional approach to

investing

The Risk Parity Alternative

16

investing

• Asset managers

• Advisors

• Investors

Risk-adjusted returns

» Investment industry has not focused on risk-adjusted returns

» Asset allocation portfolios are often loaded with risky assets with

equity risk and illiquidity risk


17

equity risk and illiquidity risk

» Asset class indices are poor proxies for return premiums

» Illusion of diversification leads to risk concentration

» A paradigm shift?

From traditional to alternative

» Traditional asset allocation is a well-accepted practice

• Strategic forecasts and strategic asset allocation

• 60/40 or alike


18

• Selection underlying managers

• Passive or active vs. cap-weighted indices

• Tactical shift based on return forecasts

• Bias towards risky assets

» A rocky ride with low risk-adjusted returns

Asset managers

» Risk parity or not?

» What to with traditional asset allocation products?


19

» If risk parity, what’s the difference?

Advisors

» Embrace risk parity or not?

» Peer risk, timing risk

» Where does it belong, GTAA or alternative?


20

» Where does it belong, GTAA or alternative?

» A slice or the whole pie?

» How to fit it into the traditional advisory service?

» How to evaluate the strategy and product offerings?

» How to educate plan sponsors?

Investors

» Leverage or not?

» A slice or the whole pie?

» Why not do it ourselves?


21

» Why not do it ourselves?

» Can risk parity achieve investment objectives?• Return target, liability requirement

» What is the benchmark: cash/inflation plus, 60/40?

» Peer risks??

» What if interest rate goes up?

8 - Qian, Risk Parity · 2019. 2. 26. · The Myths and Facts of Risk Parity . ... » Private...

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Transcript of 8 - Qian, Risk Parity · 2019. 2. 26. · The Myths and Facts of Risk Parity . ... » Private...