Risk parity was thought of as a portfolio strategy that would protect investors buffeted with uncertainty. Don’t think about dollar allocations, but risk allocations; it is a better way to manage a portfolio. Unfortunately, theory does not always work in practice. Using a simple benchmark of the average return for mutual funds with 50-70% equity allocation would have had slightly better returns than the 10% risk parity index and would have done much better than the higher vol indices in 2018.
When no asset class does well and volatility is targeted at higher levels, risk parity cannot save an investor from loses. A combination of two volatility shocks, February and the fourth quarter, was enough to cause under performance. Levered into a volatility spike and then de-levered on the reversal after the spike will create a whipsaw effect. There is no safe harbor with risk parity. Does this mean investors are done with the strategy? It will still have advocates, but there will be a search for new portfolio solutions.
Set it and leave it alone portfolio management has significant costs when there are regime changes. While active discretionary management may not be a solution, systematic rules that address regime change will help with allowing for some flexibility when there is a market change.
Investors face many choices when selecting investments. Historically, the main divide was between fundamental and technical trading. The growth of computer systems for trading has introduced a potentially larger variable that will only increase as AI advances, whether in systematic (rules-based) or discretionary (human judgment) trading. In just my 20 years working in the industry, […]
Is AI the next step in the evolution of trading? History proves new tools storm the markets, then high adoption erases their edge. What can futures trading history teach us about AI’s trajectory? The 1980s: Rise of Rules-Based Trading Building on simple regression models that aimed to identify patterns across sectors, the 1980s showed that […]
What makes a futures program great? Obvious answers include excellent performance, low drawdowns, a high Sharpe ratio, or consistent returns. While everyone searches for those qualities, large money managers know that the secret to producing all of those is to build portfolios that target those goals using multiple strategies. After all, high returns and low […]