Time For A New Benchmark?
In an interesting recent paper entitled “The Risk Parity Gorilla In The Room”, Mike Rulle of MSR Indices outlined an academic quality reasoning for a better benchmark for many institutional investors than the classic 60/40 stocks and bonds portfolio. Rulle proposed using a risk-parity 50/50 portfolio that is better than the classical one in many measures, including risk-adjusted performance.
The paper is an excellent read for practitioners in the field but it does lean strongly towards the academic side. With that in mind, we wanted to take a slightly simpler and more practical look, given that the new benchmark is available on AlphaBot. To do this, we do a few comparisons. First, let us compare the S&P 500 index, the traditional 60/40 mix (built “in-house” by yours truly), and the 50/50 Risk Parity Index. Clearly, Risk Parity comes out on top right away on an absolute return basis (Figure 1) and a risk-adjusted basis (Figure 2).
The drawdown chart is particularly impressive, especially for those who may be concerned with downside protection (which, given where we are in the business cycle, seems to be everybody):
Another interesting observation comes from an Efficient Frontier chart, built from the S&P and a Fixed Income indices. Rulle touches on this in a more theoretical way in the paper, so again we want to look at this from a slightly simpler angle: when we put the 50/50 Risk Parity on it, the corresponding Risk/Return point falls considerably outside of the Efficient Frontier line:
This is not a math error. The important point here is in the fact that the frontier is built using static allocations, with the classic 60/40 mix being close to point 30 (out of 50) on the frontier, and the Risk Parity index is rebalanced dynamically to maintain, well, the risk parity. The exciting part is that such a rebalancing is not hard to do, while the benefits are obvious and long lasting (at the cost of a slightly larger turnover in the portfolio).
We definitely recommend the practitioners in the field, institutional investors and their PMs and CIOs, as well as their research analysts to take a good look at the original paper - something interesting is definitely going on in there!
Dmitri Alexeev is Co-Founder of AlphaBot
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