SAA # 2012 # Risk Parity Portfolios a Practitioner's Guide by Fulcrum

Fulcrum Research Papers – October 2012

Risk Parity Portfolios: A Practitioner’s Guide

Suhail Shaikh, CFA and Athanasios Bolmatis, PhD

At the core of most pension fund investment portfolios is an allocation to equities and

government bonds, with risk typically dominated by the former. Recognizing this lack

of diversification, some plans have moved to a more balanced risk allocation by directly

adopting a risk budget based approach or by allocating to externally managed risk

parity funds.

At Fulcrum, we have been building risk parity portfolios for many years, and this paper

summarises our approach, along with the key lessons we have learned. Risk parity

portfolios have generally outperformed equity/bond balanced portfolios in Sharpe ratio

terms over the past two decades, and this has continued to be the case since the

financial market shocks in 2008. In this paper, we comment on the selection of assets

to include in risk parity portfolios, their performance, the appropriate treatment of

volatility and correlations in building these portfolios, and the relationship between

risk parity portfolios and traditional portfolios.

We believe that the risk parity approach represents a valuable addition to traditional

investment management techniques, especially if risk parity portfolios are combined

with alpha seeking trading strategies, and are hedged against severe losses using a

permanent options based overlay. We will analyse these alpha generators, and hedging

strategies, in future research papers.


Fulcrum Research Papers – October 2012 2

Introduction

Risk parity1 portfolios have delivered strong returns over the past twenty years, with a

Sharpe ratio that has been higher than traditional portfolios of equities and bonds.

Figure 1: Historical Excess2 Performance (Jan-93 to Sep-12)

Figure 2: Cumulative Excess Performance Since 1993

1 In Figures 1 to 4, we include the following premia in the risk parity portfolio: Equity Premium, Bond Premium, EM $ Debt Spreads, High Yield Spreads, Commodity Beta, Emerging Equities (EM - DM), Equity Style (Value - Growth), Equity Size (Small - Large), Fixed Income Carry, Commodity Carry, Developed Market Currency Carry and Emerging Market Currency Carry. 2 Performance is expressed on an unfunded basis, i.e. without including the return on cash.

Equities Bonds 60/40 Risk Parity

Annual Excess Return 3% 3% 3% 10%

Volatility 15% 3% 9% 8%

Sharpe Ratio 0.2 0.9 0.4 1.3

Correlation with:

Equity Premium 0.9 0.0 0.9 0.6

Bond Premium -0.2 0.9 -0.1 0.0

Equity/Bond 0.5 0.7 0.6 0.5

Source: Fulcrum Asset Management

Global Equities

Global Bonds

GlobalBalanced

60/40

Risk Parity

0

100

200

300

400

500

600

700

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012




Even since the financial crisis began in early 2007, risk parity portfolios have continued

to generate attractive risk-adjusted returns.

Figure 3: Historical Excess Performance (Jan-07 to Sep-12)

Figure 4: Cumulative Excess Performance Since 2007

In our opinion, it is likely that risk parity portfolios will continue to outperform

traditional portfolios over the long term, but there are many issues related to their

construction that need to be carefully addressed.

Equities Bonds 60/40 Risk Parity

Annual Excess Return -2% 4% 1% 7%


Sharpe Ratio -0.1 1.3 0.1 0.9

Correlation with:

Equity Premium 0.9 -0.1 0.9 0.5

Bond Premium -0.4 0.8 -0.3 -0.1

Equity/Bond 0.4 0.7 0.5 0.3


Global Equities

Global Bonds

GlobalBalanced

60/40

Risk Parity

50

60

70

80

90

100

110

120

130

140

150

Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12




The philosophy behind risk parity

At its core, the risk parity approach to asset allocation seeks to improve diversification

versus traditional portfolios of equities and bonds. More specifically, its philosophy can

be summarised as follows:

Maximise diversification at each point in time by equalising risk across a

variety of return sources, each of which has a positive expected Sharpe ratio and

a less than perfect correlation with other return sources; and

Maximise diversification through time by maintaining a relatively stable

volatility profile that prevents long-term performance being overly dependent

on periods of high volatility.

Under the assumption that all investments offer the same risk-adjusted return, the

optimal portfolio is one that equalises risk across investments. This portfolio represents

the special case of risk parity within a broader risk budgeting framework. Approaches

that maintain a focus on risk contributions but deviate from risk parity – for example

based on differences in expected Sharpe ratios – are more accurately described as risk

budget portfolios. Our approach to risk parity falls into this latter category.

The issues addressed in this paper

The paper outlines our thoughts on the following questions that are of interest to risk

parity investors:

Which risk premia do you include in risk parity portfolios?

How have these risk premia performed historically?

Are you confident these risk premia will perform in the future?

Which risk premia do you exclude?

How does volatility targeting impact return distributions?

Can you control the volatility of your risk parity portfolio?

What correlations do you assume between the premia?

How correlated are risk parity portfolios with equities and hedge funds?

How have portfolios of risk premia performed historically?

What are the main pitfalls of risk parity approaches?



Which risk premia do you include in risk parity portfolios?

Risk parity based portfolio construction techniques can be used to combine a wide

variety of investments, including risk premia – both traditional and alternative – as

well as alpha strategies. At Fulcrum we focus on liquid risk premia. These can be

classified in many ways, including by asset class, economic regime and the need for

leverage.

In the table below, we classify risk premia as either traditional, which are typically

present in long only portfolios, or alternative, which form the building blocks of many

hedge fund portfolios.

Figure 5: The Liquid Risk Premia

The main criteria on which we judge whether these return sources should be included

in risk parity portfolios are as follows:

Have they provided positive Sharpe ratios historically?

Do they offer a genuine risk premium?

Do they exploit a behavioural anomaly?

Do they provide diversification benefits to portfolios dominated by equity risk?

Asset Class

Traditional (Long Only)

1 Equity Premium Equity

2 Bond Premium Fixed Income

3 EM $ Debt Spreads Fixed Income

4 High Yield Spreads Fixed Income

5 Commodity Beta Commodity

Alternative (Long Short)

6 Emerging Equities (EM - DM) Equity

7 Equity Style (Value - Growth) Equity

8 Equity Size (Small - Large) Equity

9 Fixed Income Carry Fixed Income

10 Commodity Carry Commodity

11 Developed Market Currency Carry Currency

12 Emerging Market Currency Carry Currency

13 Volatility Equity & FI

Return Source



How have these risk premia performed historically?

Figure 6 shows the realised Sharpe ratio from October 1997 to September 2012 for each

of the risk premia listed in Figure 5, as well as a more recent period beginning in 2007.

Due to data limitations, the volatility premium has been excluded from this analysis3.

Figure 6: Realised Sharpe Ratios

The key highlights are as follows:

Over the full sample period, all risk premia have generated positive Sharpe

ratios, with the exception of the equity style premium.

The long term performance of credit premia (high yield bonds and emerging

market debt) is disappointing, especially given the fall in credit spreads and

high yields offered by these assets. (We explain some of the reasons behind this

later.)

The bond, fixed income carry and commodity carry premia have performed best

and most consistently.

3 The volatility premium has a very high historical Sharpe ratio. However, the Sharpe ratio can be a misleading way of evaluating short volatility strategies.

-1.5

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-0.5

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1.5

2.0

Eq

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Bo

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Hig

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Oct-97 to Sep-12

Jan-07 to Sep-12




Risk-adjusted returns delivered by currency carry premia have dropped versus

their prior history, but remain positive.

Since 2007, only the equity and equity style premia have generated negative

Sharpe ratios.

Are you confident these risk premia will perform in the future?

Identifying genuine risk premia is a challenging exercise that requires judgement. Of

the thirteen premia listed in Figure 5, we are confident that ten will compensate

investors for assuming specific forms of risk, such as real interest rates, inflation,

default, growth and insurance (see Figure 20). The remaining three premia exploit

behavioural biases, for example those that stem from leverage aversion (currency carry

premia) or information asymmetry (equity size premium).

Although we believe that all thirteen premia have a valuable role within liquid risk

parity portfolios, our confidence in three of the premia is slightly lower than in the

others. As a result, we deviate from strict risk parity and allocate moderately lower risk

budgets to them. These risk premia are as follows:

Commodity beta; by investing in commodity futures it is possible to gain

exposure to changes in commodity spot prices and the return associated with

carry, which relates to potential gains made from owning commodities for

which forward prices are lower than current spot prices. Over the very long

term, returns from commodity futures have been dominated by the carry return

while spot prices have generally provided an insignificant contribution,

especially in real terms. Currently, most commodities are in contango (forward

prices are higher than current spot prices), which puts a downward bias on the

return to commodity futures and reduces our confidence in this source of

returns. Nevertheless, we include commodities in risk parity portfolios, given

the likely diversification they will provide (versus equities and bonds) if

agricultural or energy commodities suffer from supply shocks.

Equity style; the recent underperformance of value stocks could signify the

erosion of a historic behavioural anomaly that has seen value stocks outperform

growth stocks over many decades. Alternatively, it may represent a highly

attractive opportunity for mean reversion. Given the robust performance of this

premium over the very long term, we still believe this risk premium belongs in

risk parity portfolios. However, we are investigating ways of broadening the

value premium across other asset classes.



Developed market currency carry; with interest rates close to zero across most

developed economies, higher yielding carry currencies offer only a marginal

yield pick-up versus lower yielding funding currencies. At the same time, the

former are generally more overvalued. Although we expect developed market

currency carry to generate a positive Sharpe ratio, our confidence in this

potential return source is lower than it has been historically. Meanwhile,

emerging market currency carry strategies continue to be underpinned by

significant interest rate differentials between currencies, giving us relatively

more confidence in the potential returns from this risk premium.

Which risk premia do you exclude?

In our risk parity portfolios, we include all suitable liquid risk premia. There are,

however, several risk premia that offer compensation for investing in illiquid assets,

such as convertible bonds, commercial mortgage backed securities (CMBS) and event

driven strategies. While it may be logical for long-term investors to allocate part of their

portfolios to these assets and extract the illiquidity premia, we exclude them for a

number of reasons:

First, risk parity approaches require regular rebalancing to reflect changes in

volatility forecasts; as volatility forecasts rise, positions are typically reduced

and vice versa. Rebalancing exposures can be challenging if investments are

made in illiquid assets that cannot be readily liquidated, as was the case during

the financial crisis.

Secondly, illiquid assets can behave in highly unpredictable ways during periods

of market turmoil, when liquidity typically dries up. In order to capture the

liquidity premium, investors need to be willing to provide liquidity during these

times, i.e. not reduce positions in line with the surge in volatility. A risk parity

approach, however, is biased towards selling assets at exactly the time when the

liquidity premium is at its highest4.

Finally, our risk parity approach offers high liquidity to investors, which makes

it unsuitable for the fund to invest in any illiquid return streams that would

create a dangerous liquidity mismatch.

4 While the related problem of buying high and selling low applies to all assets within a risk parity portfolio (since volatility typically rises after price declines, and vice versa), it has historically been of much less significance to liquid premia. In addition, this problem can be moderated for liquid assets through option based hedging strategies, which we utilize in all of our risk parity portfolios. It is much more difficult to hedge illiquidity risk.



How does volatility targeting impact return distributions?

If we ignore the impact of correlations, it is possible to construct a risk parity portfolio

by allocating a weight to each premium that is inversely proportional to its forecasted

volatility, thereby allocating each premium with an equal risk budget5. This process of

volatility targeting helps normalise return distributions for most premia since dynamic

(real-time) volatility forecasts are generally better at estimating future volatility than

static (long-term) forecasts, which do not reflect changing market conditions. In

addition, it also tends to improve risk-adjusted returns. The main driver behind these

improvements relates to better diversification; volatility targeting allows risk premia

(and portfolios) to be more diversified through time, i.e. equally influenced by periods

of high and low volatility. In contrast, static volatility assumptions tend to result in

portfolios that are disproportionately dependent on market outcomes during periods of

high volatility.

Figure 7: Monthly Return Distribution of S&P 500 Index Futures

5 An equivalent approach is to first scale each asset (using leverage or cash) such that it targets the same level of risk and then allocate fixed weights across them. If the premia’s volatility is below the target, as tends to be the case with the bond premium, for example, leverage can be used to achieve the volatility target. On the other hand, if the premia’s volatility is above the target, as tends to be the case for the commodity premium, for example, exposure can be cut in favour of cash to reduce volatility.

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

-18% -14% -10% -6% -2% 2% 6% 10% 14% 18%

S&P 500 Index Return, without Volatility Target

S&P 500 Index Return, with 8% Volatility Target




For example, Figure 7 shows the distribution of monthly returns for S&P 500 Index

futures, both before and after volatility targeting. To target 8% volatility, we use

standard volatility estimates (σ) that are based on recent realised returns and allocate a

weight (w) to the S&P 500 Index, such that w*σ = 8%6. As can be seen, adopting a

volatility target for the S&P 500 Index has historically improved skewness (the

distribution is less negatively skewed) and kurtosis (the distribution is less fat-tailed).

In addition, it has also increased the Sharpe ratio from 0.3 to 0.5.

Figure 8 goes on to show how the volatility of returns for the S&P 500 Index is also

much more stable after a volatility targeting approach has been adopted. Again, similar

results can be shown for the majority of risk premia listed in Figure 5, including all the

alternative risk premia.

Figure 8: 3 Year Realised Volatility of S&P 500 Index Futures

The only notable exceptions are with credit premia, such as high yield corporate bonds

and emerging market debt. Here, estimating volatility is a much more challenging task.

6 This is the methodology used in constructing the risk premia component of Fulcrum Alternative Beta Plus (FAB+). For example, if the volatility estimate for the S&P 500 Index is 20% at the beginning of a month, we invest 40% in the S&P 500 Index future and generate 40% of its return for that month. Correspondingly, if the volatility estimate is 10%, we invest 80% in the S&P 500 Index future.

S&P 500 Index Futures, without Volatility Target

S&P 500 Index Futures, with 8% Volatility Target

0%

5%

10%

15%

20%

25%

1995 1997 1999 2001 2003 2005 2007 2009 2011




Approaches that use realised volatility as a guide to future volatility have tended to

worsen the overall return distribution (Figure 9) and done little to stabilise the overall

volatility profile. This is because they tend to be over exposed to credit before the onset

of financial panics (reflecting artificially depressed volatility levels) and under exposed

during the ensuing recovery (reflecting the sharp rise – often by many multiples – in

realised volatility levels). The implication is that applying standard risk budget

approaches to credit premia can result in a tendency to buy high and sell low.

Figure 9: Monthly Return Distribution of US High Yield Corporate Bonds

Overall, volatility targeting helps normalise return distributions and improve risk-

adjusted returns for all premia listed in Figure 5, except for the credit premia.

Importantly, once these (normalised) premia have been combined into a risk parity

portfolio, the overall portfolio’s return distribution and risk-adjusted returns are also

improved.

0%

5%

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20%

25%

30%

35%

40%

45%

-18% -14% -10% -6% -2% 2% 6% 10% 14% 18%

US High Yield Index Return, without Volatility Target

US High Yield Index Return, with 8% Volatility Target




Can you control the volatility of your risk parity portfolio?

Risk parity approaches, especially those consisting of many uncorrelated premia, tend

to result in stable realised volatility profiles. In order to illustrate this, we create four

risk parity portfolios using the premia listed in Figure 5 (each with a volatility of 8%):

1. Bond and equity risk premia only (“BERP”);

2. All traditional risk premia (“TRP”);

3. All alternative risk premia (“ARP”); and

4. All risk premia (“RP”).

When constructing these portfolios, we size allocations such that each premium

contributes the same level of risk under the assumption of perfect correlation.

Figure 10: 3 Year Volatility of Risk Parity Portfolios (BERP, TRP, ARP and RP)

As can be seen in Figure 10, TRP, ARP and RP have all delivered relatively stable

realised volatility profiles that are generally close to the 8% target. The two asset BERP

portfolio has seen a less stable volatility profile, reflecting the unstable correlation

between equities and bonds. Overall, however, the volatility of diversified risk parity

portfolios can be controlled effectively.

Equity/Bond (BERP)

Traditional (TRP)Alternative

(ARP)

All Risk Premia (RP)

4%

5%

6%

7%

8%

9%

10%

11%

12%

1995 1997 1999 2001 2003 2005 2007 2009 2011




What correlations do you assume between the premia?

When modelling correlations, there is a trade-off between reacting to perceived

changes in correlations and exposing portfolios to sudden correlation breaks. There is

no perfect solution since conservative assumptions (for example, zero or perfect

correlations) that result in more robust portfolios during times of crisis are sub-optimal

in normal times, while dynamic correlations can have the reverse problem.

Figure 11 shows the correlation between each traditional risk premium and the overall

TRP portfolio; with the exception of the bond premium, all are highly correlated with

TRP. As a result, we assume that equities, commodities and credit (emerging market

debt and corporate high yield) are perfectly correlated with each other.

Figure 11: 3 Year Rolling Correlations with TRP

For the bond premium, however, correlations vary significantly over time. As a result,

we assume a zero correlation between major government bonds and other traditional

risk premia. Over the last two years, this assumption has resulted in lower bond

exposure than more traditional risk parity approaches. Going forward, we believe that

10 year bond yields will not sustainably remain below 1%, which limits the likely upside

in bonds. Meanwhile, our approach is likely to be less vulnerable to rising bond yields.

Equity Premium

Commodity Beta

Bond Premium

EM $ Debt

High Yield

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-0.6

-0.4

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0

0.2

0.4

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0.8

1

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013




Figure 12: 3 Year Rolling Correlations with BERP

Figure 13: 3 Year Rolling Correlations with BERP

EM-DM Equities

Equity Size

Equity Style

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0.1

0.2

0.3

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1995 1997 1999 2001 2003 2005 2007 2009 2011 2013


CommodityCarry

DM FX Carry

EM FX Carry

FI Carry

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-0.4

-0.2

0

0.2

0.4

0.6

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013




Turning to alternative risk premia, Figures 12 and 13 show their low average correlation

with a BERP portfolio. Importantly, this diversification benefit has increased since the

financial crisis, reinforcing the valuable role played by alternative risk premia within

risk parity portfolios. The tendency of these correlations to fluctuate in fairly wide

bands around zero, leads us to assume a zero correlation between them and other risk

premia.

How correlated are risk parity portfolios with equities and hedge

funds?

Since the risk in most pension fund portfolios tends to be dominated by equities,

approaches that are less correlated with equities are more valuable to most investors.

As can be seen in Figure 14, TRP portfolios tend to be highly correlated (0.8) with

equities while ARP portfolios tend to be uncorrelated (0.1).

Figure 14: 3 Year Rolling Correlation with Equities

As shown in Figure 15, TRP and RP are more correlated with hedge funds than they are with

equities. Nevertheless, we believe that investors considering risk parity funds should allocate from

existing equity exposure, reflecting the dominance of equity risk in most portfolios.

Equity/Bond (BERP)

Traditional (TRP)

Alternative (ARP)

All Risk Premia

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013




Figure 15: 3 Year Rolling Correlation with Hedge Funds (HFRI Fund of Funds Index)

How have portfolios of risk premia performed historically?

Figure 16 shows the performance characteristics of the four risk parity portfolios

(BERP, TRP, ARP and RP) and Figure 17 illustrates their cumulative returns.


Equity/Bond (BERP)

Traditional (TRP)

Alternative (ARP)

All Risk Premia(RP)

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013


BERP TRP ARP RP

Annual Excess Return 8% 6% 10% 10%


Sharpe Ratio 1.0 0.7 1.3 1.3

Correlation with:

Equity Premium 0.7 0.8 0.1 0.6

Bond Premium 0.7 0.0 0.0 0.0

Equity/Bond 1.0 0.6 0.1 0.5





The key highlights are as follows:

Between 1993 and 2012, a risk parity portfolio of equities and bonds (BERP) has

been highly correlated with both equity (0.7) and bond (0.7) premia.

A portfolio of traditional risk premia (TRP) has underperformed BERP,

reflecting its lower exposure to the bond premia. Meanwhile, rising correlations

between credit, commodities and equities have resulted in a high correlation of

TRP with the equity premium (0.8).

A portfolio of alternative risk premia (ARP) has strongly outperformed BERP

and has been uncorrelated with both equity (0.1) and bond (0.0) premia.

A portfolio of all risk premia (RP), which combines ARP with TRP, has also

performed well, with a moderately high correlation with the equity premium

(0.6).

Figure 18 shows the relative ranking of calendar year excess returns for each of the risk

premia (excluding volatility). For example, so far in 2012, the best performing risk

premium is high yield, while the worst performing is the equity style premium. While

we continue to investigate ways of systematically timing risk premia, our current

Equity/BondBERP

Traditional(TRP)

Alternative(ARP)

All RiskPremia

(RP)

0

100

200

300

400

500

600

700

800

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012




research suggests that timing is unlikely to work given the lack of persistence in relative

performance.

Figure 18: Calendar Year Excess Performance Ranking by Risk Premium (1997 – 2012)

Importantly, however, a risk parity portfolio (RP) that combines all these traditional

and alternative risk premia has generated positive returns in 11 out of the last 16 years,

and in 3 out of the 4 years since the financial crisis (Figure 19).

Figure 19: Calendar Year Profitability of Risk Premia (1997 to 2012)

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Equity Premium 1st

EM-DM Equities 2nd

Equity Size 3rd

Equity Style 4th

Commodity Beta 5th

Commodity Carry 6th

DM FX Carry 7th

EM FX Carry 8th

Bond Premium 9th

FI Carry 10th

EM $ Debt 11th

High Yield 12th


2012 7 5 Positive

2011 4 8 Negative

2010 10 2 Positive

2009 10 2 Positive

2008 5 7 Negative

2007 6 6 Negative

2006 10 2 Positive

2005 10 2 Positive

2004 11 1 Positive

2003 11 1 Positive

2002 9 3 Positive

2001 7 5 Positive

2000 6 6 Negative

1999 10 2 Positive

1998 4 8 Negative

1997 7 5 Positive

Performance

of Risk Premia

Portfolio

Number of

Negative Risk

Premia

Year

Number of

Positive Risk

Premia



What are the main pitfalls of risk parity approaches?

Over the course of an economic cycle, well-constructed risk parity portfolios should

deliver better risk-adjusted returns than traditional portfolios, especially if equities

perform at, or below, their long-term average. However, risk parity approaches have

several limitations that need to be addressed during portfolio construction:

1. There is uncertainty over the expected return for each risk premium. While

historical returns and economic intuition can provide useful guidance, the

success of risk parity approaches is ultimately contingent on risk premia

delivering positive Sharpe ratios. We believe that each of the thirteen risk

premia we have included will generate positive Sharpe ratios.

2. The construction of risk parity portfolios requires establishing effective and

dynamic measures of risk; volatility is most commonly used, but can have

severe limitations. For example, volatility levels tend to spike in periods of

broad-based panic, such as 2008, and are very depressed in calmer periods.

These problems can be moderated by using more sophisticated volatility

measures and controls.

3. Risk parity portfolios require regular rebalancing to maintain their equal risk

allocation across return sources. This results in higher transaction costs than

buy and hold portfolios. We rebalance bi-weekly and use a tracking error based

approach, thereby reducing transaction costs; and

4. Leverage should preclude the inclusion of illiquid return sources, such as

convertible bond arbitrage and event driven strategies, from risk parity

portfolios, thereby excluding a potentially useful source of returns. We exclude

all illiquid premia from our portfolios.



Conclusion

Figure 20: Summary of Individual Risk Premia

In this paper, we address some of the key issues faced by risk parity investors. Our

main conclusions are summarised in Figure 20 and noted below:

All thirteen liquid risk premia shown in Figure 20 should be included in risk

parity portfolios, while illiquid risk premia should be excluded.

There are some grounds for concern on expected returns for commodities beta,

equity style and developed market currency carry. As a result, we allocate

slightly less risk to these premia.

Many traditional risk premia (excluding the bond premium) have become

highly correlated over recent years, reducing their ability to provide

diversification. Fortunately, alternative risk premia continue to provide an

uncorrelated source of attractive risk-adjusted returns.

Particular care should be taken when modelling volatility for credit premia

given the tendency for their volatility to jump sharply. More sophisticated

volatility models can help mitigate this problem.

Selective use of the most stable correlations can improve portfolio robustness

and performance.

In our experience, the performance and volatility characteristics of risk parity portfolios

can be improved further by adding alpha generating trading strategies and hedging

overlays7. We will return to these in subsequent research papers.

7 This forms the basis of Fulcrum Alternative Beta Plus (FAB+).

(1997-2012) (2007-2012)

Traditional (Long Only)

1 Equity Premium a a High a High

2 Bond Premium a a a Low a High

3 EM $ Debt Spreads a a a High High

4 High Yield Spreads a a a High High

5 Commodity Beta a a a High a Medium

Alternative (Long Short)

6 Emerging Equities (EM - DM) a a a Low a High

7 Equity Style (Value - Growth) a Low a Medium

8 Equity Size (Small - Large) a a a Low a High

9 Fixed Income Carry a a a Low a High

10 Commodity Carry a a a Low a High

11 Developed Market Currency Carry a a a Medium a Medium

12 Emerging Market Currency Carry a a a Medium a High

13 Volatility a a a Medium a High

Correlation

to Equities

Overall

Confidence

Positive Sharpe Ratio

Return Source

Genuine

Risk Premia

Behavioural

Anomaly

Conducive

to Volatility

Targeting



Telephone: +44 (0) 20 7016 6450

E-mail: [email protected]

Website: fulcrumasset.com

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can and do make discretionary decisions on a frequent basis and reserves the right to

do so at any point.

Past performance is not a guide to future performance. Future returns are not

guaranteed and a loss of principal may occur.

Fulcrum Asset Management LLP is authorised and regulated by the Financial Services

Authority of the United Kingdom (No: 230683) and incorporated as a Limited Liability

Partnership in England and Wales (No: OC306401) with its registered office at 6

Chesterfield Gardens, London, W1J 5BQ. Fulcrum Asset Management LP is a wholly

owned subsidiary of Fulcrum Asset Management LLP incorporated in the State of

Delaware, operating from 767 Third Avenue, 39th Floor, New York, NY 10017.

© 2012 Fulcrum Asset Management LLP. All rights reserved.

mailto:[email protected]

mailto:[email protected]

SAA # 2012 # Risk Parity Portfolios a Practitioner's Guide by Fulcrum

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