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J O U R N A L

THEORY & PRACTICE FOR FUND MANAGERS

The Voices of Influence | iijournals.com

O F

FALL 2012 Volume 21 Number 3

not to mention opacity.com FEIFEI LI is a director of research at Research Affiliates in Newport Beach. However. no asset class EFFICIENT A LGORITHMS FOR COMPUTING R ISK PARITY PORTFOLIO WEIGHTS JOI-CHAVES. This way. CA. Many possible interpretations of “risk contribution” exist. we define what we hope to be a fairly noncontroversial definition of equal risk contribution. FEIFEI LI. We lean heavily on the earlier work of Maillard. Our focus. shakernia@rallc. and therefore contribution. However. At the high level. and adjunct professor in finance at UCLA Anderson School of Management. institutional investors often default to a 60/40 equity/bond strategic portfolio without any pretense of mean-variance optimality. a 60/40 portfolio variant earns much of its return from exposure to equity risk and little from other sources of risk. instead. the 60/40 portfolio is dominated by equity risk because stock market volatility is significantly larger than bond market volatility.com OMID SHAKERNIA is a senior researcher at Research Affiliates in Newport Beach. We assert that the literature on risk parity stands to benefit from greater congruence in the definition of “risk contribution” and transparency in methodologies. Theoretically. This then allows us to present two simple and transparent algorithms for producing risk parity portfolios. making this portfolio approach fairly underdiversified. the difficulties in accurately estimating expected returns. however. is technical in nature. We adopt their equal risk contribution definition as the objective for our risk parity portfolio and develop two simple algorithms to efficiently compute our risk parity asset weights.com M arkowitz’s [1952] portfolio optimization has long been the theoretical foundation for traditional strategic asset allocation. and Teiletche [2010]. Furthermore. the 60/40 portfolio structure.1 In practice. Roncalli. First.indd 150 can be dominant in driving the portfolio volatility.com JASON HSU is chief investment officer at Research Affiliates in Newport Beach. these allocations are generally too small to meaningfully impact the portfolio risk. especially given the time-varying nature of asset class risk premiums and their joint covariance. CA. CA. and there are considerable disagreements. In this sense. li@rallc. in methodologies adopted by different providers. we do not make an attempt to argue that the risk parity approach is superior relative to the traditional 60/40 structure or to mean-variance optimal portfolios. means the MVO approach has been enormously challenging to implement in reality. In this article.Efficient Algorithms for Computing Risk Parity Portfolio Weights DENIS CHAVES. hsu@rallc. AND OMID SHAKERNIA DENIS CHAVES is a senior researcher at Research Affiliates in Newport Beach.2 This makes examining risk parity strategies difficult. JASON HSU. if all asset classes have roughly the same Sharpe ratios and the same FALL 2012 8/20/12 1:26:44 PM . very few of the research articles documenting the benefits of the risk parity approach state the portfolio construction methods clearly. CA. Risk parity represents a portfolio strategy that attempts to address the equity risk concentration problem in standard 60/40-like balanced portfolios. has largely been motivated by the 8% to 9% expected portfolio return one can attach to the portfolio mix. Even if one adds alternative asset classes to the 60/40 asset allocation. chaves@rallc. which proposes an approach to compute an equal risk contribution portfolio. the risk parity concept assigns the same risk budget to each asset component.

as these are direct measures of total portfolio risk. and Teiletche [2010] extend the naïve risk parity weighting approach to account for a more f lexible correlation assumption. However. This section first presents a rigorous mathematical definition for risk parity using the equal risk contribution notion of Maillard. By contrast. We then demonstrate the algebraic solution as well as the required numerical steps to compute portfolios with non-negative weights. the numerical optimization necessary to identify the optimal portfolio weights can be tricky. The idea behind risk parity is more straightforward: Simply equalize all the TRCs. respectively. The results for the minimum-variance portfolio are well known and are presented here since they provide an interesting comparison. Note. and Teiletche [2010]. Roncalli. measured here as the standard deviation. we provide readers with two alternative approaches to compute sensible risk parity portfolio weights. The logic behind this requirement is simple: If the MRCs of any two assets were not the same. To see why this is the case. To illustrate the intuition of the approach. ( RP ) : ∂σ p = ∂σ p = ∀i j ∂xi ∂x j ∂σ p ∂σ p xi ⋅ = xj ⋅ =λ ∂xi ∂x j (6) ∀i j where κ and λ are constants to be found. we also reference the minimum-variance portfolio extensively. we specify the problem slightly differently to demonstrate that our approach leads to different and. The second one is the total risk contribution (TRC) TRC i DEFINING RISK PARITY rp where σij is the covariance between assets i and j. Although our initial motivation is similar to Maillard. throughout the initial exposition.5 Again. notice that ∑ N TRC i i =1 ∑ N i =1 ( ) xi ⋅ cov ri rp = σ 2p (5) Next. most importantly. Notice that the minimum-variance portfolio can be obtained by equalizing all the MRCs. The first one is the marginal risk contribution. Roncalli. We also present two measures of risk contribution that will be useful for defining and understanding risk parity portfolios. and Teiletche [2010]. and require special software. our contribution is largely technical. time-consuming. Roncalli. the standard naïve risk parity weighting (weight assets by 1/vol) could be interpreted as optimal under the Markowitz framework. We demonstrate that our algorithmic approaches result in reasonable ex post “equal risk contribution” and produce attractive portfolio returns. simplified solutions. we characterize the risk parity portfolios in terms of risk contributions and show how to find their weights without any optimizations. which is well-understood and intuitive. This is because the algebraic nuances are best illustrated by comparing and contrasting to the minimum-variance portfolio calculation. 3.4 Maillard. Translating these descriptions into equations we get ( MV ) : and ∂σ p which tells us the impact of an infinitesimal increase in an asset’s weight on the total portfolio risk. the return and weight of each individual asset i. and σ ii σ i2 is the variance of asset i. FALL 2012 JOI-CHAVES. we discuss the application of the MRC measure on the minimum-variance portfolio. one could increase the contribution of one asset and decrease that of the other to obtain a slightly lower portfolio variance.correlations. the algorithms proposed here do not involve optimization routines and can output reasonable portfolio weights quickly with simple matrix algebra. Using ri and xi to denote. the portfolio’s return and standard deviation can be written as N ∑x ⋅r i =1 MRC i = i (1) i σp N N ∑∑ i =1 j =1 i j σ ij (2) ∂xi (r r ) N = ∑ x j σ iij i j =1 (3) p xi ⋅ ∂σ p ∂xi N = ∑ xi x j ⋅ σ ij = xi j =1 (r r ) i p (4) which gives us a way to break down the total risk of the portfolio into separate components.indd 151 THE JOURNAL OF INVESTING 8/20/12 1:26:44 PM .

The first one minimizes ∑ ∑ N N i =1 j =1 (TRC i T TRC j ) 2 (10) subject to ∑ i =1 xi = 1 and. and Teiletche [2010]. This alternative approach has the potential to find a solution even when the original one fails. To do this. The usual approach to solving this type of problem is to write down the entire expressions and try to isolate the weights. with weights restricted between zero and one. In other words. and in the Appendix. This expression. that this naïve solution is still important and useful for our proposed approaches. To deal with this challenge. The direction we follow here is very different. The algorithms we propose do not allow us to specify constraints on the weights. We show below. with the simple algorithms presented here. However. combined with the fact that ∑ N x =1 yields i =1 i 1 xi = ∑ N j =1 βi 1 (9) βj The difficulty with Equation (9) is that the βi s on the right-hand side are a function of the xi s on the lefthand side. Roncalli. The weighting by 1/σ is of course the naïve risk parity solution commonly referenced in the existing literature. using ι to denote a vector of ones and 1/x to denote the vector [1/x1 ⋅⋅⋅ 1/xN ]′. Notice that Equation (8) has a striking similarity to an eigenvector-eigenvalue equation. one cannot find the betas without the weights. even without any constraints on the weights. we can write ( MV ) : Ω⋅x = κ ⋅ι (7) ( RP ) : Ω⋅x = λ⋅ 1 x (8) betas. is equivalent to a vector of covariances. a numerical optimizer is required. EFFICIENT A LGORITHMS FOR COMPUTING R ISK PARITY PORTFOLIO WEIGHTS JOI-CHAVES. our algorithms compute the same “optimal” risk parity solution as the original Maillard. A mathematical interpretation of risk parity portfolios gives us some intuition about the problem and helps in understanding the convergence properties of the optimization. if desired. but the weights depend on the Ω−1 ⋅ (11) This expression presents an easy way to obtain a second solution to the risk parity problem: simply apply one of the iterative algorithms presented below to the inverse of the covariance matrix. if one wants to impose non-negativity constraints (x ≥ 0) on the weights. However. The second approach is a more complicated optimization that involves nonlinear constraints.indd 152 1 1 = ⋅x x λ FALL 2012 8/20/12 1:26:46 PM . recall that Ω ⋅ x. which is one of the most studied problems in matrix algebra. For instance. To illustrate the challenges in finding the optimal risk parity weights in the general case. and we refer interested readers to their article. and then invert the solution found. Ω ⋅ x = λ ⋅ x. 1/σ. in which case. Roncalli. but this approach does not work with these equations. the optimal weights are proportional to the inverse of the standard deviation. Finding the solution for the risk parity portfolio. Moreover. and can be implemented in any programming language or spreadsheet capable of executing simple arithmetic and matrix operations. it still retains some of the properties of its linear counterpart. but we show in the numerical examples later that for most applications with real data. they have the advantage of not requiring optimization software. Maillard. which can quickly and easily compute risk parity weights that provide true equal risk contribution. there is no longer reason to favor the naïve 1/σ approach. And although it is nonlinear. it helps to write them in matrix form. notice that dividing Equation (8) by the variance of the portfolio and rearranging gives us xi = λ/βi. we obtain the well-known solution x = Ω−1 ⋅ ι/(ι′ ⋅ Ω−1 ⋅ ι). Ω−1. and Teiletche [2010] propose two optimization problems to find the optimal risk parity weights. 0 ≤ xi ≤ 1. is a different matter. Solving the expression in Equation (7) and imposing the constraint ι′⋅x = 1.To find the solution for these two problems. notice that by multiplying Equation (8) by Ω−1 and rearranging we obtain N The solution for the minimum-variance portfolio is straightforward. Thus. where Ω is the covariance matrix and x is the vector of weights. Simple solutions exist only in the special situation where assets are assumed to have identical pairwise correlation.

Moreover. Algorithm 2: Power Method To understand the second algorithm. If not. Equation (9) tells us what condition the weights have to satisfy to be an optimal solution. since we are looking for a root of the system. using this equation we can update the weights to satisfy the conditions. it also seems to provide a recipe on how to proceed. By iterating the multi- THE JOURNAL OF INVESTING 8/20/12 1:26:48 PM . These dependencies create a circular relationship that precludes us from finding a simple analytical solution for the weights. λ (0) (any number between zero and one) and a stopping criterion or threshold. as shown by Equation (9) above. but usually converges faster. Now. 1/σ). But now that the weights have changed. one is interested in finding the solution to F(y) = 0. This procedure can be repeated many times and one can observe that with each iteration. 3. If the condition n+ n y( ) − y( ) < ε (17) (13) Of course this solution is only an approximation. ε. Fortunately. and by imposing the restriction that the weights add up to one: 1⎤ ⎡ ⎢Ω ⋅ x − λ ⋅ x ⎥ F ( y ) = F ( x.Algorithm 1: Newton’s Method Our first algorithm is an application of Newton’s method to solving a system of nonlinear equations. J(y (n)) and y (n+1) using the formulas above. the conditions are closer and closer to being satisfied. This can be easily done by using Equation (8). we found that it tends to be more robust. FALL 2012 JOI-CHAVES. given an approximate solution y (n). In other words. the TRCs from all assets would not be the same. This procedure is inspired by the “power method. Recall that we can write a linear approximation to this system around any point c using a Taylor expansion F ( y ) ≈ F (c ) + J (c ) ( y c ) (12) where J(c) represents the Jacobian (matrix) of F(y) evaluated at point c. we set F(y) = 0 and solve for y: y −1 c − ⎡⎣ J (c )⎤⎦ ⋅ F (c ) ( ) ( ) −1 n n y( n ) − ⎡ J y ( ) ⎤ ⋅ F y ( ) ⎣ ⎦ (14) and. Imagine that one would start with an initial guess for the weights and calculate the betas associated with them.” one of the simplest iterative algorithms to find an eigenvector from a general matrix. which in turn depend on the weights. Ω. The remaining step is simply to write the risk parity problem as a system of nonlinear equations. However. and its Jacobian is a N + 1 × N + 1 matrix ⎡ ⎛ 1⎞ ⎢Ω + λ ⋅ diag ⎜⎝ 2 ⎟⎠ J (y ) = J (x ) = ⎢ x ⎢⎣ ι' ( ) 1⎤ − ⎥ x⎥ 0 ⎥⎦ (16) where diag x12 represents a diagonal matrix with elements equal to 1/xi2 . Start with an initial guess for portfolio weights x (0) (equal weight or the traditional risk parity approximation. such as a matrix inverse. this method requires slightly more complicated operations. the betas have also changed and the conditions aren’t satisfied anymore. Thus. Writing the system in general form. Aside from incredible luck. When compared with the second algorithm. the weights are a function of the betas. notice that. ) = ⎢ ⎥=0 N ⎢ ∑ xi − 1 ⎥ ⎣ i =1 ⎦ (15) This represents a system with N + 1 equations and N + 1 variables (x and λ). Define y (0) = [x (0)′ λ(0)] ′.6 2. but the idea behind the method is that repeated iterations of Equation (13) will get us closer and closer to the optimal solution. if the method converges.indd 153 1. reaching the optimal solution even when the second algorithm fails in special situations. go back to step 2. stop. then y (n) → y. Calculate F(y (n)). one can calculate n+ y( ) The following steps illustrate this iterative process: is satisfied.

we present this solution and a numerical example in the Appendix. but in many numerical applications (see the Applications section of this article) this is exactly what we found. We refer to this risk parity portfolio as optimal risk parity. both algorithms compute the same “optimal” risk parity solution as the original Maillard. Our primary goal is to evaluate various portfolio strategies relative to EFFICIENT A LGORITHMS FOR COMPUTING R ISK PARITY PORTFOLIO WEIGHTS JOI-CHAVES. Roncalli. An interesting special case occurs when we have one or more uncorrelated assets (or groups of assets). The only point that requires some explanation is the stopping condition in the final step. In the interest of space. However.indd 154 FALL 2012 8/20/12 1:26:50 PM . as shown in Equation (8). the algorithm finds the optimal weights within each group of assets but is not able to find the optimal combination between the two uncorrelated groups. the first algorithm almost guarantees convergence and can be more efficient in terms of computation time. The fact that a well-defined covariance matrix is symmetric and positive definite gives us some confidence in this regard. Fortunately. one can find the eigenvector associated with the largest eigenvalue in absolute terms. 2. The improved computational efficiency relative to the traditional optimization approach using quadratic programming with nonlinear constraints makes it possible to backtest a large number of optimal risk parity portfolios constructed on different universes for careful in-sample and out-of-sample examinations. One alternative would be to use Equation (10). which ignores the covariance information and therefore does not achieve true “parity” in asset class contribution to portfolio volatility. or when all assets in one group are uncorrelated with all assets in another group. β(i n ). These cases are unlikely to be found in actual datasets. It’s important to emphasize that individual correlations between two assets can be zero. 3.) In the end. calculate the new weights as 1 x (n+ i ) = β(i ) N ∑ j=1 1β(n) j n (19) and go back to step 2. with one extra step: after calculating the covariances (or betas). we think that expressing it as a standard deviation is more succinct and easier N to program. In our simulations. with respect to the current portfolio x (n). The algorithm described above does the same. More specifically. Generally. We have no mathematical proof that this second algorithm will generate a positive (or in fact any) solution. as compared to naïve (1/σ) risk parity. To formalize the iterative process just described. equivalently. ε. In this section. Ωn ⋅ x. Ω ⋅ x. using three different datasets. both criteria work equally well. 1/σ) and a stopping criterion or threshold. based on the equal risk contribution and more realistic assumptions on asset class covariances. before repeating the step. we illustrate the property of risk parity portfolios. given the nice mathematical properties of such matrices. Start with an initial guess for portfolio weights x (0) (equal weight or the traditional risk parity approximation. Note that while the second algorithm is simpler to implement. we define the procedure or algorithm with the following steps: 1. there is a very simple strategy to fix this problem and still obtain an optimal solution. as such. If not. as all the TRCs have to be equivalent.plication many times or. so the average percentage TRC is just 1/n. but could arise in artificial examples or through restrictions imposed on the covariance matrix. stop. raising the matrix to a high power. we found that in such cases this second algorithm tends to cycle between two different partial solutions but never converges. one needs to invert and renormalize the resulting vector. algorithm 1 is our preferred method for calculating risk parity weights. (Recall that ∑ i =1 xi βi = 1. If the condition 2 N ⎛ (n ) 1 1⎞ n x ⋅ β(i ) − ⎟ < ε ∑ i =1 ⎜ i ⎝ N −1 N⎠ (18) is satisfied. and that a special case occurs only when one asset is uncorrelated with all other assets. Calculate betas for all individual assets. APPLICATIONS The proposed algorithms in this article allow us to efficiently compute the portfolio weights for risk parity portfolios. and Teiletche [2010] equal risk contribution solution using nonlinear optimization.

and HY bonds (6. It is meant to replicate a well-diversified investment with exposure to different types of risk. Excess returns and Sharpe ratios are calculated relative to the 30-day Treasury Bill (IA SBBI US 30 Day TBill TR). S&P 500 (IA SBBI S&P 500 TR). and equal risk contribution (optimal) risk parity. show that portfolio optimization is highly sensitive to errors or uncertainty in expected returns.81%. high-yield bonds (BarCap US Corporate High Yield TR). [2011]. which allows for more useful comparisons. whereas the best performers are REITs (8.81%).67%). Our secondary goal is to compare the performance of these strategies over long horizons. minimum variance. As Exhibit 1 shows. among others. Asset Classes The first dataset comes from Morningstar EnCorr and contains 10 asset classes from January 1991 through March 2012: BarCap Agg (BarCap US Agg Bond TR). This measure is widely used by economists to measure income inequality (or wealth concentration) and then compare inequity across countries. We start by reporting some summary statistics— annualized excess return. there is significant variation across assets in terms of returns and volatilities. The Gini coefficient has an advantage over the more popular Herfindahl measure of portfolio concentration in that it is always unitized between 0 and 1 and. and MSCI emerging markets (MSCI EM GR). For a comparison between naïve risk parity and MVO approaches. Roncalli. commodities (DJ UBS Commodity TR). and Teiletche [2010] applied the Gini coefficient as a measure of portfolio concentration by computing risk contribution inequality (or risk contribution concentration). Michaud [1989] and Best and Grauer [1991]. MSCI EM (7. long-term Treasuries (BarCap US Treasury Long TR). We restrict all portfolios to have non-negative weights.indd 155 THE JOURNAL OF INVESTING 8/20/12 1:26:51 PM . investment grade bonds (BarCap US Corp IG TR).7 The Gini coefficient ranges between zero (perfect equality) and one (perfect inequality). MSCI EAFE (MSCI EAFE GR). Commodities have the lowest return at 1. Maillard. When evaluating asset class weight and risk concentration. and Uppal [2008] show that equal weighting is generally superior to (maximum Sharpe ratio) MVO portfolios due to estimation errors in expected returns. we report the Gini coefficient. Garleppi. EXHIBIT 1 Asset Classes FALL 2012 JOI-CHAVES.optimal risk parity in terms of asset weight concentration and asset class risk contribution concentration. we choose to use strategies that require only estimates of second moments (variances and covariances). for our specific study. REITs (FTSE NAREIT All REITs TR). long-term credit (BarCap US Long Credit TR). Thus. 1/σ (naïve) risk parity. More recently.46%). is more variable across different portfolio strategies. DeMiguel. We compare four annually rebalanced strategies: equal weight. These strategies have in common that they require no estimates of expected returns. we refer readers to Chaves et al. annualized volatility and correlations—over the entire sample.

in the top graph. The two risk parity strategies have very similar weights. Later.The most volatile asset classes are MSCI EM (23. that since forward-looking information was used for computing portfolio weights. we used the variance and covariance estimates computed from the entire sample for constructing the backtested portfolios.85%) and MSCI EAFE (16. This dataset is interesting because of these differences and because of some potential for diversification as seen in the correlations across asset classes. showing that we EXHIBIT 2 Portfolio Weights and Risk Allocations (10 Asset Classes) EFFICIENT A LGORITHMS FOR COMPUTING R ISK PARITY PORTFOLIO WEIGHTS JOI-CHAVES.71%) and IG bonds (5. we report results using only non-forward– looking data to test the impact of noisy estimation of the risk parameters on these methodologies. HY bonds and commodities have small allocations and most other asset classes have a zero weight. while the least volatile ones are the BarCap Agg (3.indd 156 FALL 2012 8/20/12 1:26:53 PM .51%).97%). the strategies are not real-time investable. Exhibit 2 shows. The perfect foresight portfolio solution addresses the efficacy of various portfolios in creating “risk” parity when the risk parameters are known. Minimum variance is heavily concentrated in the BarCap Agg Index with a weight of roughly 90%.96%). Note. the portfolio weights assigned to each asset class assuming that we have perfect knowledge of the steady-state asset class risk parameters—that is. REITs (18.

for instance. Equal weight. the Gini coefficients comparisons are more extreme and more illustrative. Unsurprisingly. which shows the risk contribution of each asset class as a function of the total portfolio variance. has a value of zero at each rebalance date. highlighting their concentration in a small number of asset classes. have volatilities of 7. These portfolios give us a more nuanced understanding of the strategies when we estimate the asset class risk parameters with noise and when these risk parameters are time varying rather than constant over the full sample period. equal-weight and the two risk parity strategies have similar SR of roughly 0.04 instead of a zero Gini coefficient as one might expect. We omit an asset class if it does not have five years of data at the rebalance date. we examine the Gini coefficient associated with the allocation to asset classes (or asset class weight concentration). While the minimum-variance. at each annual rebalance. the naïve and optimal strategies have coefficients of 0. respectively. outper- FALL 2012 JOI-CHAVES.48.90. therefore. The naïve risk parity is not very far behind. The dataset is limited to monthly frequencies. arising from its 80%+ allocation to the BarCap THE JOURNAL OF INVESTING 8/20/12 1:26:54 PM .82 and 0.12. The optimal risk parity solution has perfectly distributed risk allocation.39. since these strategies are investable. its volatility is dominated by duration risk. Both risk parity strategies have lower coefficients of 0. 0. confirming their superior asset class weight parity. which is intuitive given its low volatility and correlations with other asset classes. minimum variance has the lowest volatility amongst the various portfolio strategies. is significantly more concentrated in asset class risk. The minimum-variance portfolio is heavily concentrated in its allocation to the BarCap Agg Index.14 and 0. The 60/40 result is clearly unsurprising because it is well known that the 60/40 portfolio volatility is largely dominated by equity risk. respectively. Minimum-variance and the 60/40 portfolio have very high coefficients of 0. which have SRs of 0.83. The equal-weight portfolio has a relatively larger exposure to the more volatile asset classes (equities) and a relatively small exposure to less volatile ones (bonds).4% and 7. We also simulate the performance of annually rebalanced. First. and 0. These results are confirmed in the lower graph of Exhibit 2. Note. For each strategy. specifically. however. we include the traditional 60/40 equities/bonds portfolio for comparison. respectively. 60/40. and equally weighted portfolio have coefficients of 0. no-look-ahead strategies.EXHIBIT 3 Performance (10 Asset Classes) can achieve excellent risk diversification with the naïve 1/σ method. In terms of risk allocation to each asset class. at only 6%. is provided by the Gini coefficients for the various methodologies. This explains why equal weight has a nonzero value of 0. of greater relevance for assessing the usefulness of the different methods. The two risk parity strategies (naïve and optimal). Perhaps more surprising is the observation that the minimumvariance portfolio.5%.indd 157 forming minimum-variance and the 60/40 portfolio. Exhibit 3 shows the results.72. but then the portfolio weights drift with price movements (and the Gini coefficient drifts upward away from zero) during the year until they are rebalanced again at year end. respectively. which is generally considered a lowrisk portfolio. The most interesting insight. we calculate the Gini coefficient for each month and then report the average coefficient over the entire sample. displaying only minor deviations from the optimal solution.30 (naive).29 (optimal) and 0.8 Both risk parity strategies have significantly lower Gini coefficients when compared to the other strategies.49 and 0. In terms of Sharpe ratio.65. they are. we use the previous five years of data (60 observations) to estimate the covariance matrix.

the ex post Gini could deviate significantly from the ex ante expectation. as correlations and volatilities might be time varying and/ or imprecisely measured.indd 158 FALL 2012 8/20/12 1:26:55 PM . the asset class risk allocation Gini coefficient for the optimal risk parity is not zero. We also note that asset class risk contribution as defined by Equation (4) is different from the portfolio’s risk factor exposure as defined by the emerging literature on risk factor–based risk parity strategies (see Bhansali [2011]. Chaves et al. Note. it is only slightly more concentrated in its asset class risk allocation relative to the optimal risk parity portfolio. Therefore. since we can compute the optimal risk parity weight exactly using the algorithms proposed in this article. which can be non-robust (see Chaves et al. corn (DJUBSCN). and Orszag [2012]). [2012]. cattle (DJUBSFC). coffee (DJUBSKC). cocoa (DJUBSCC). copper (DJUBSHG). However. and Lohre. [2011]). there is little reason to favor the naïve solution. the optimal portfolio does have an ex ante risk allocation Gini coefficient of zero with respect to the historical covariance matrix. Opfer. We note that the naïve risk parity portfolio does a surprisingly commendable job of sourcing volatility risk from each asset class evenly. brent crude (DJUBSCO). because we compute risk contribution using ex post realizations. However. At each rebalance date.Agg Index. EXHIBIT 4 Performance (Commodities) EXHIBIT 5 10 Industries EFFICIENT A LGORITHMS FOR COMPUTING R ISK PARITY PORTFOLIO WEIGHTS JOI-CHAVES. cotton (DJUBSCT). Commodities The second dataset comes from Bloomberg and includes 28 commodity futures sub-indices calculated by Dow Jones from January 1991 through June 2012: aluminum (DJUBSAL). parity in asset class contribution to the portfolio’s total volatility should not be confused with parity in the true underlying risk factor exposure.

natural gas (DJUBSNG). Similar to before. we estimate the covari- ance matrix using daily data and a backward-looking three-year window. and zinc (DJUBSZS).indd 159 THE JOURNAL OF INVESTING 8/20/12 1:26:57 PM . nickel (DJUBSNI). again. and variances for commodity futures can be found easily in Erb and Harvey [2006]. tin (DJUBSSN). sugar (DJUBSSB). among others. the risk parity strategies are much less concentrated in EXHIBIT 6 Portfolio Weights and Risk Allocations (10 Industry Portfolios) FALL 2012 JOI-CHAVES. counter-cyclical. soybean oil (DJUBSBO). closely followed by the naïve and optimal risk parity portfolios with SR of 0. heating oil (DJUBSHO). orange juice (DJUBSOJ). The Gini coefficient for the equally weighted commodities is 0.33 and 0. respectively. lead (DJUBSPB). the portfolios are also rebalanced annually.25. In the interest of space we do not report the summary statistics for the commodity components and jump directly to the portfolio simulations. or Chaves. live cattle (DJUBSLC). gasoline (DJUBSRB). By comparison. silver (DJUBSSI).35. Kalesnik. platinum (DJUBSPL). soybean meal (DJUBSSM). Gorton and Rouwenhorst [2006].57. and Little [2012]. However. wheat (DJUBSWH). and pro-cyclical commodities).gas oil (DJUBSGO). the availability of daily data allows us to use a shorter rolling window to capture time-varying covariances while simultaneously improving estimation reliability statistically. WTI crude (DJUBSCL). correlations. The minimum-variance portfolio of commodities again has a relatively high asset class risk contribution Gini coefficient at 0. gold (DJUBSGC).29. lean hogs (DJUBSLH). soybeans (DJUBSSY). Exhibit 4 shows that the equal-weight portfolio outperforms the other portfolios with a Sharpe ratio of 0. Historical returns. The commodity dataset is interesting because of the high diversity in risk characteristics in commodities (including acyclical.

For equities. Again.and 49-industry universe. the more sophisticated risk parity approach. 8. We do not include the summary statistics for the other universes due to space constraint.10 (optimal) and 0. Using the entire sample. we also show that in all cases. The result of this is seen in Exhibit 6. but less E X H I B I T 7 than in the first (asset classes) and second Performance (10 Industries) (commodities) examples. Again. The data sample extends from January of 1965 through to December of 2011. with only minimum variance showing some variability in portfolio weights or risk contribution. for the 25 size x book-to-market portfolio. the third contains 25 portfolios sorted on size and book-to-market. all four strategies look strikingly similar. which we confirm with our calculations not reported here. minimum variance strategy has the highest Gini. the optimal risk parity portfolio provides a better ex post “parity” in risk contribution from the underlying investment than naïve risk parity. high-tech. durables. which uses the full covariance matrix information to ensure “true” risk parity. we observe the same pattern in the Gini coefficient for asset class risk contribution. energy. we use a three-year window of daily returns to estimate the covariance matrix. the asset class risk contribution Gini coefficients are 0. Exhibits 7. variances. the different strategies have very similar performance in terms of Sharpe ratios. In each case. the Gini coefficient for the two risk parity portfolios and the equally weighted portfolio are the same. Exhibit 5 shows the summary statistics for the 10 industry portfolios. where it displayed a significantly better SR relative to equal-weighting and the two risk parity strategies. the minimum-variance EFFICIENT A LGORITHMS FOR COMPUTING R ISK PARITY PORTFOLIO WEIGHTS JOI-CHAVES. and pairwise correlations than the previous two examples using universes of asset classes and commodities. notice that the correlations are positive and the majority of them are in excess of 0. portfolios are rebalanced annually. manufacturing. utilities. and 9 show the portfolio characteristics for equity portfolio E X H I B I T 8 strategies constructed from the three Performance (49 Industries) universes. retail. always results in better “parity” in asset class risk contribution. Further.5. There is some variation in returns and variances. For the 10. The first data universe contains 10 industry portfolios (non-durables. we consider three different equity universes obtained from Ken French’s data library.indd 160 FALL 2012 8/20/12 1:26:58 PM . However. Again. health. we confirm that naïve risk parity based on 1/σ is generally effective at improving “parity” in asset class contribution to the total portfolio risk relative to other standard portfolio strategies. This suggests that the pairwise correlations and the volatilities are similar for the universe. and others). the optimal risk parity is more risk balanced than naïve risk parity than the equally weighted portfolio. These universes are interesting because they represent relatively more homogeneous universes—the “securities” in each of the universes are relatively more similar in returns. Equities portfolio constructed from the 25 size x book-to-market portfolios is the only exception. However.their asset class risk contribution. the second contains 49 sub-industry portfolios. similar to what is done in the commodities section. From our portfolio backtests using various datasets. We note that in each case. telecom.18 (naïve).

since it is rare to find an asset that is perfectly uncorrelated with all the other assets in the selection universe. because they do not involve optimization and are based on simple matrix algebra. and the optimal risk parity weights. This issue is not very FALL 2012 JOI-CHAVES. However. because the algorithm cycles indefinitely and never converges. The improved computational efficiency allows us to more effectively calculate the optimal risk parity portfolio weights and simulate portfolio backtests for examination. i. Our algorithms represent a significant simplification relative to the traditional optimization methods for solving nonlinear minimization. there is a simple solution to this problem. both naïve and optimal. in which each asset component equally contributes to the total portfolio variance. all the assets in the first group have zero correlation with all the assets in the second group.indd 161 important in practice. respectively. The total variance of this portfolio can be written as 2 (N1 2 1 N1 ) σ (2N ) + w 22 ⋅ σ (2N ) 1 2 (A-2) Because the total risk contributions are already equalized within each block. Applying the algorithm proposed in the text. That is. as a result. Denote the weights 1 2 of this portfolio by w 1 and w 2 = 1 – w 1. introduce zero correlation assumption. uncorrelated assets provide a challenge to the second algorithm.EXHIBIT 9 Performance (25 Size and Book-to-Market Portfolios) CONCLUSION In this article we propose two algorithms for computing portfolio weights for risk parity portfolios. do provide superior diversification in asset class risk contribution. but the solution can be easily extended to more complex situations. in all situations provides the best ex ante and ex post “parity” in asset class risk contribution.e. x( N ) ⎡⎣ x N1 1 x N1 + N 2 ⎤⎦ '. which we can now compute easily with the proposed algorithms. We compare the optimal risk parity portfolio to the naïve risk parity solution based on 1/σ and to other popular portfolio solutions like equal weighting and minimum variance weighting. Fortunately.. We introduce here the simple case of two blocks of assets uncorrelated with each other. We find that risk parity portfolios. each of the included asset classes does provide relatively more equal contribution to the total portfolio volatility versus other portfolio strategies. APPENDIX WHAT ABOUT UNCORRELATED ASSETS? As discussed in the text. The optimal risk parity portfolio. or that the average TRCs are the same: w12 ⋅ σ (2N ) 1 N1 = w 22 ⋅ σ (2N ) 2 N2 (A-3) The reason for this requirement is straightforward: We want the TRC of each asset in the first block to be the same as THE JOURNAL OF INVESTING 8/20/12 1:26:59 PM . x( N1 ) ⎡⎣ x1 x N1 ⎤⎦ '. one can find the optimal risk parity weights. for the portfolio 2 composed only by the last N 2 assets. in which the first N1 are uncorrelated with the last N 2. as measured by the risk allocation Gini coefficient. Denote the standard deviations of these two individual risk parity portfolios by σ (2N ) and σ (2N ) . Consider a universe of N = N1 + N 2 assets. we could still argue that in some special situations one might want to impose certain restrictions or views on the correlation matrix and. so that the two-asset covariance 1 2 matrix is ⎡ σ (2N ) ⎢ 1 ⎢ 0 ⎣ 0 ⎤ ⎥ σ (2N ) ⎥ 2 ⎦ (A-1) The next step involves finding the optimal risk parity portfolio between these two assets: the optimal portfolio x( N ) and the optimal portfolio x( N ) . for the portfolio composed only by the first N1 assets. the only requirement imposed on this portfolio is that the TRCs are inversely related to the number of assets in each portfolio.

118% x 3 = 57. Finally. or ERC. and Teiletche [2010]. Thus. multiplying the weight of each block by the weight of each asset inside the block. Equation (A-3) is easily solved by: N1 w1 = x3 = σ (2N ) x4 = 1 N1 + σ (2N ) N2 1 σ (2N ) 2 (A-4) N2 w2 = 1 N1 σ (2N ) 2 N2 + σ (2N ) 1 σ (2 ) 2 x( N 1 ⎡w ⋅ x w ⋅ x ⎤ ' ⎣ 1 (N1 ) 2 (N 2 ) ⎦ N2 ) ' (A-6) Clearly. See Hansen and Hodrick [1980] and Fama and French [1984] for evidence on time-varying currency returns. 3 Bridgewater Associates promotes implementing risk parity strategies as a passive management. Roncalli. The standard deviations are equal to 10%. Finally. yielding a weight of 57. and 40%.66% 66% ⋅ 57. we obtained the solution The complete vector of N1 + N 2 weights is finally calculated with ' 1 FALL 2012 8/20/12 1:27:02 PM .46% = 24.86 86% % ⋅ 42. This gives us 1 x1 = x2 = and 1 01 +1 01 1 1 01 = 66.886% 02 x 2 = 33.26% (A-9) x 4 = 42. 2009] and Peters [2009] for productprovider white papers discussing their respective risk parity strategies. Since each of the two blocks contains only two assets. 2 See Qian [2005.46% = 18.the TRC of each asset in the second block. Equation (A-3) simplifies to the 1/σ rule. 5 These authors refer to risk parity portfolios as equally weighted risk contribution portfolios. and Wolldridge [1987] and Engle. when a particular guess leads to a solution with EFFICIENT A LGORITHMS FOR COMPUTING R ISK PARITY PORTFOLIO WEIGHTS JOI-CHAVES. See Bollerslev. by treating asset classes as uncorrelated (or assuming constant correlations between them). the 1/σ approximation is the actual solution for each block. 4 For an exact mathematical proof of this statement. 6 Different initial guesses might lead to different solutions.33% 33% ⋅ 57. the first two assets are independent from the last two assets. Roncalli and Teiletche [2010].indd 162 (A-8) which is the original solution obtained. Because both blocks have the same number of assets. and Robins [1987] for evidence on time-varying volatility in equity and bond markets. one obtains a standard deviation of 12.14% 04 x1 = 66.54% for block one and 42. 20%. consider the numerical example with four assets obtained from Maillard.20% ENDNOTES 1 See Merton [1980] for a discussion on the impact of time-varying volatility on the estimate for expected returns. As an illustration of the procedure. Lilien. see Maillard.66% (A-7) 02 02 +1 = 33. respectively. Engle.14 14% % ⋅ 42. See Cochrane [2005] for a survey discussion on time-varying equity premium and models for forecasting equity returns.46% for the second block. 30%. The correlation matrix is given by ⎡1 0 ⎤ ⎢ ⎥ 0 8 1 0 ⎥ ρ= ⎢ ⎢0 0 0 0 1 0 ⎥ ⎢ ⎥ ⎣0 0 0 0 −0 5 1 0 ⎦ 01 02 +1 = 57.54% = 38.54% = 19.65% for the first block and 17. We prefer the first denomination because it has become standard among both practitioners and academics. See Campbell [1995] for a survey on time-varying bond premium.36% (A-5) NUMERICAL EXAMPLE WITH UNCORRELATED ASSETS 1 03 1 03 +1 Using the weights in the equations above.333% 02 = 42.14% for the second block.

Vol. V. and R.” Working paper. simply trying a different guess might lead to the desired solution with nonnegative weights. R. L... “Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis. T. J. 323-361. “Diversifying Risk Parity.P. Roncalli. R. 2 (March/April 2006). and R. Gorton. Vol. 20. R. and K.” PanAgora Asset Management White Paper. 62.” Financial Analysts Journal. G.. Opfer.” Research Affiliates working paper.F. Chaves. 2005. Engle. Vol. Kalesnik. 4. y i . September 2005. Cochrane.B. “A Capital Asset Pricing Model with Time-Varying Covariances. Vol. 9. 1 (February 1987). Vol. 60-70. pp. FALL 2012 JOI-CHAVES. pp. M. Orszag. 5 (October 1980). is calculated by f irst sorting them in non-decreasing order (y i ≤ y i+1) and then computing: N G N2 ∑ i ( yi y ) . Bollerslev. pp. Vol. 1 ( January/February 1989). 45. “On Estimating the Expected Return on the Market: An Exploratory Investigation. No. and B. “Portfolio Selection. Teiletche.” PanAgora Asset Management White Paper.” FQ Perspective. pp. 2012. No.panagora.B.” The Journal of Investing.C. 7.com/assets/PanAgora-Risk-Parity-The-Next-Generation. 3 (Summer 1995). pp. No.pdf. No. 31-42.” Journal of Financial Economics. NJ: Princeton University Press. et al. 2 (March 1987). pp. “Balancing Betas: Essential Risk Diversification. and J. REFERENCES Best. No.com/assets/PanAgora-Risk-Parity-Portfolios-Efficient-Portfolios-Through-True-Diversification. Chaves. and J.” The Journal of Portfolio Management. No. “Forward and Spot Exchange Rates. Available at http://www. panagora. 391-407. and G. T. Hansen. 8. Available at http://www. No. 2 (March/April 2006). 14. 7 The Gini coefficient for a set of allocations or risk contributions. E. Merton. Campbell. No. When computing the Gini coefficient for the risk allocations.pdf.. Michaud.com or 212-224-3675. and C. No.. “Risk Parity Portfolios™: The Next Generation. defined in Equation (4)) divided by the total portfolio variance. Markowitz. No. pp. ——. pp. D. E. pp. 2012.negative weights. Revised Edition. Vol.com/downloads/2009_02_Balancing_Betas. Lohre. 36. 2 (February 2009). H. “Estimating Time Varying Risk Premia in the Term Structure: The ARCH-M Model. 62.” Journal of Economic Perspectives. “The Properties of Equally Weighted Risk Contribution Portfolios.” The Journal of Investing. Princeton. No. THE JOURNAL OF INVESTING 8/20/12 1:27:04 PM . 129-152.F. we use the full sample to calculate variances and covariances. 2009. “Beyond Risk Parity. R.. 315-342.” Journal of Monetary Economics. pp. Little.” Econometrica. C. Fama. H. ——.” Financial Analysts Journal..Y. 69-97..” Journal of Political Economy. 116-131. To order reprints of this article. Vol. Vol. 4 (December 1980). please contact Dewey Palmieri at dpalmieri@ iijournals. “Risk Parity Portfolio vs. Other Asset Allocation Heuristic Portfolios. V. 1 (March 1952).” Journal of Finance. and R.. “Some Lessons from the Yield Curve.indd 163 Peters. 2 (Summer 1991). J. pp.pdf. Bhansali.F. pp. “On the Sensitivity of MeanVariance-Efficient Portfolios to Changes in Asset Means: Some Analytical and Computational Results. Asset Pricing. 319-338. “Facts and Fantasies about Commodity Futures. Maillard. Hodrick. “The Strategic and Tactical Value of Commodity Futures.” Journal of Political Economy. 6.M. 1 (Spring 2011).M. S. 55. Grauer. Vol. Vol.” Research Affiliates Working paper. November 2009. 3 (November 1984). “A Comprehensive Evaluation of Commodity Strategies. “The Markowitz Optimization Enigma: Is ‘Optimized’ Optimal?” Financial Analysts Journal. 20. 4 (Summer 2010). Harvey. i =1 8 The percentage of risk allocation to each asset is its total risk contribution (TRC. Vol. E. D. S. Vol.G.firstquadrant.H.R.B. No.J. No. Qian. Erb. Vol. Wooldridge. 829-853. Available at http://www.” Review of Financial Studies.P. Robins. D. pp. 2012. 77-91. “Risk Parity Portfolios™: Efficient Portfolios through True Diversification. Engle. No. 137-147. No. Rouwenhorst. Vol.R. 108-118.. pp. 1 (Spring 2011). 96.J. “A Risk Factor-Based Approach to Asset Allocation. 88. Lilien. 47-68.

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