March 24, 2013: PP vs. Risk Parity Funds

Before jumping into the body of this post, please be sure to check out the new "long term performance" section. I have vastly improved it.

Risk parity is a buzzword in pension finance right now. Ray Dalio of Bridgewater popularized the concept and he has become one of the biggest names in the institutional investment community. His strategy is simple: 1) Don't try and predict the future. 2) Allocate your capital across different asset classes that respond differently to different economic environments so that you have a neutral portfolio.

This should sound familiar because it is exactly what the Permanent Portfolio does. The risk parity guys complicate things by weighting assets inversely to their volatility (which changes over time), but the principles are the same. After all gold, stocks, and LTT all have roughly equivalent volatility so the equal split with the PP's weightings is no coincidence. It is essentially a risk parity strategy.

AQR and Invesco have launched a couple of funds within the last few years, and I think it will be very interesting to watch their performance vs. the PP over time. Although they are guided by essentially the same framework as the PP, their execution of the philosophy is much more complicated (and expensive).
These charts will update automatically every month, so be sure to check back in the future if you are curious about the relative performances.

3 comments:

  1. So the risk weighted vs value weighted "argument" is sort of a non-issue since each asset class has roughly the same volatility? Just simply split the total sum four ways (gold, stocks LTT, cash) and re-balance yearly or use the 35/15 rule?
    Just trying to get that straight in my head.

    I had to complicate matters by using six ETF's (some hybrids as you say) to try to make a neutral portfolio which required some additional calculation. Thanks for that, by the way.

    This information you provide on this site is really useful to someone like me who only now realizes that a PP-like portfolio is the only way to go. Since recently switching to a neutral portfolio, it's helpful to have this sort of site where I can gage my results. Just goes to show quality trumps quantity.

    Jeff

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    Replies
    1. Hi Jeff,

      I think that is the correct way to view it. This hasn't always been true, but looking over the past three years LTT,gold, and stocks have all had roughly equivalent volatility. So equal weighting them happens to give us risk parity which is pretty convenient! If something structural ever changed where the volailities became very different, I might consider weighting them by 1/vol. For now though, simplicity takes the cake.

      Check out minute 51:00 of this video feauturing Ray Dalio.
      http://www.youtube.com/watch?v=SFaRazMpxcM

      -Ryan

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  2. Hey Ryan,

    When LTT yields are at really low historic levels, do you think it's possible to have a lesser allocation to them and still have them be risk-equal with stocks and gold? My understanding is that the closer yields get to zero, due to convexity, the more potential LTTs have to provide protection for a 4X25 PP when prices are rising. But I don't like holding 25% of my assets in LTTs when yields are at, say, 2% - 2.5%. It just seems to me that at that point, the interest rate risk is too great. Put another way, they would seem to have much higher odds of dragging down a portfolio than lifting it up.

    Oh, so that you have enough information, the bonds I am currently holding have durations that range from 15 to 19 years. My guess is that you'll say I'd need longer durations in order to justify reducing the percentage of my PP that is allocated to LTTs. Hope this is clear and thanks in advance for your feedback!

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