Risk-Parity: Is This Portfolio For You?

A Close Look At A Risk-Parity Portfolio*

The idea of risk-parity has been around for a number of years, if not by name, certainly by concept.  Risk-Parity is an alternative method of constructing portfolios.  Instead of building a portfolio around allocation of capital the portfolio is emphasis is placed on allocation of risk.  All eleven portfolios tracked here at ITA Wealth Management are built on the capitalization model.  Is this the best approach?  Google risk-parity and one finds links to all sorts of articles on the subject.  Some references support the idea of risk-parity while others argue it only works in certain types of markets.  It is currently a popular concept as it worked well over the last twelve years.  What might a "risk-parity" portfolio look like going forward. 

In the following Quantext Portfolio Analysis (QPP) I show the projections for a twenty-seven ticker portfolio.  Three individual stocks are combined with 24 ETFs.  In a later post I will drop off the individual stocks to see if it makes much difference to stick strictly with ETFs.  Bond ETFs such as BND and BIV were eliminated from the options as the portfolio ends up being skewed in favor of those lower risk investments.  When included, bonds drive the projected return down into the 3% level.  This is unacceptable.  It makes little sense to tilt a portfolio toward bonds when we know the current bond bubble is going to explode all over investors.

In the first screenshot the analysis uses four years of data.  In the second slide, the analysis incorporates three years of data.  I would have used a five-year period except for the fact that several ETFs have not been in existence that long and short-records distort the final results.

As one might expect, the projected growth is lower than we normally see when portfolios are build using the standard capitalization asset allocation model.  We pay for that additional growth by higher risk.  In the following portfolio the risk comes down to 11.8% where we normally see portfolio uncertainty values around 15%.  Look over the Historical Data and readers will see this portfolio was a respectable performer over the last four years.  The time frame picks up the last of the bear market of 2008 and early 2009.  This is exactly why risk-parity is currently so popular.

Scan down over the Percentage of Funds column and you see nearly equal distribution till one comes to TIP.  This low risk ETF garners a high percentage of the portfolio in the risk-parity approach.

Before going into exactly how I came up with this portfolio, look at the three-year analysis in the following screen shot.  Once more, the historical performance is a little better than the return for the S&P 500.  Active mutual fund managers would be thrilled with this performance.

Investors approaching retirement and unwilling to put their hard-earned portfolio at risk should take a close look at the risk-parity model for portfolio creation.

How does one go about calculating what percentage to allocate to a particular ETF or stock?  As yet, I have not figured out how to incorporate the risk-parity model into the TLH Spreadsheet.  I generate the values inside Geoff Considine's Quantext Portfolio Planner software.  My method is not all that elegant, but it works.  Here is the thinking process, if interested.

1) Find the Standard Deviation (SD) for each investment.  QPP contains this data in the Historical worksheet.

2) Calculate variance by squaring SD.

3) Find the reciprocal of the variance found in Step 2.  Call each individual calculation R, which is used in Step 6.

4) Sum the reciprocal values found in Step 3.  Call this D for Denominator.

5) 1+ 1/D = N where N is the numerator for the following calculation.

6) Weight (W) = N/R/100.  The final division by 100 converts the value to a percentage.

Once step 6 is calculated, that percentage is automatically assigned to the specific ETF and the QPP analysis follows as usual.

* Revised on 9/13/2012.  More testing is required to make sure these instructions are correct.