Risk Parity. Fundamentals. Edward E. Qian. PMD CFA

Transcription

1 Risk Parity Fundamentals Edward E. Qian. PMD CFA CRC Press Taylor & Francis Group Boca Raton London New York CRC Press is an imprint of the Taylor & Francis Croup, an informa business A CHAPMAN & HALL BOOK

2 Risk Parity Fundamentals Edward E. Qian. PhD CFA CRC Press Taylor & Francis Croup Boca Raton London New York CRC Press is an imprint of the Taylor & Francis Group, an informa buslness A CHAPMAN & HALL BOOK

3 Contents Preface, xiii Author, xvii CHARTER 1. An Introduction to Risk Parity Principle 1^ 1.1 RISK CONTRIBUTION AND US FINANCIAL INTERPRETATION Risk Contribution A Three-Asset Example Financial Interpretation of Risk Contribution Risk Contribution and Loss Contribution RISK PARITY Risk Parity Portfolio Construction Risk Parity Portfolios with Three Assets EFFICIENT PORTFOLIOS THROUGH TRUE DIVERSIFICATION Eggs in One Basket From Risk Contribution to Loss Contribution Risk Parity Portfolios "Optimality" of Risk Parity Portfolios Targeting Risk/Return Level with Appropriate Leverage Using Risk Parity Portfolios 15 CHARTER 2. The "Colors" of Risk Premiums HY AS AN ASSET CLASS: EQUITY IN BONDS' CLOTHING Fundamental Linkage between HY Bonds and Equities A First Glance Other Unattractive Features of the HY Bonds HY Bonds as an Equity Asset Annual Return Volatility Liquid HY Bonds 24

4 vi Contents Correlation Analysis Conclusion ROLL YIELDS, PRICES, AND COMMODITY RETURNS Roll Yield and Third-Grade Math Roll Yield is Not Value Return Attribution Gold and Copper Cross-Sectional Analysis Conclusion DO CURRENCIES HAVE RISK PREMIUMS? Risk Premium No Reason for Currency Risk Premium Where Is Currency Risk Premium? Keep Searching for Currency Risk Premiums Carry Risk Premium Conclusion 42 CHARTER 3 The "Death" of Interest Rate Risk Premium ARE BOND YIELDS TOO LOW? The Answer Is Yes The Answer Is Maybe Not The Answer Is Actually No The Answer Is it Depends DU RATION, YIELD VOLATILITY, AND BOND EXPOSURE Duration with Declining Interest Rates UST Yields and Yield Volatilities Risk Parity Treasury Exposures Global Trend in Yields and Yield Volatilities Conclusion DO FORWARD RATES HAVE ANYTHING TO DO WITH FUTURE RATES? "Prediction Is Very Difficult, Especially about the Future" Forward Rates Financial Interpretations of Forward Rates Forward versus Future Empirical Examination of Forward Interest Rate 62

5 Contents vii Comparison of Forward Rates and Actual Rates Conclusion 66 CHARTER 4 See the Forest for the Trees SPEAR AND SHIELD SEE THE FOREST FOR THE TREES Miss the Forest for the Trees Mind the Forest When and What Do We Worry about? Defense against Future Inflation Shocks Dynamic Risk Allocation Deleveraging Additional Inflation Exposures Conclusion RJSK-ON RISK-OFF AND RISK PARITY Risk On Risk Off Asset Correlations under Risk On Risk Off Broad Asset Class Correlations Correlations of Fixed-Income Assets Correlations of Equity Asset Classes Correlations of Commodities Causes of Risk On Risk Off Implications to Asset Allocation Portfolios Traditional Balanced Asset Allocation Portfolios Risk Parity Asset Allocation Portfolios Return Implication of Risk On Risk Off Conclusion THE RISK PARITY CONUNDRUM: RISING RATES AND RISING RETURNS Do Not Let Bond Math Fool You Risk Parity Is Not a Levered Bond Portfolio Dynamic Risk Allocation Conclusion NO MORE RISK PARITY DEBATE? No Debate GMO 7-Year Return Forecasts 95

6 viii Contents Portfolio Expected Returns Additional Advantage of Risk Parity Have the Critics Been Right about Risk Parity So Far? Conclusion 99 CHARTER 5 - The "Peculiarity" of Risk Parity Portfolios WHO IS AFRAID OF LEVERAGE? Modern Economy and Leverage Institutional Investors and Leverage Danger of Hidden Leverage Risk Parity and Leverage Conclusion PORTFOLIO REBALANCING AND DIVERSIFICATION RETURNS OF LEVERAGED PORTFOLIOS Rebalancing Long-Only Unlevered Portfolios Diversification Return Rebalancing Leveraged Portfolios Negative Diversification Returns: Cautionary Tales of Inverse and Leveraged ETFs Diversification Return of Leveraged Risk Parity Portfolios Conclusion BENCHMARKING RISK PARITY Investment Objectives and Benchmarks Serving Multiple Masters Sharpe Ratio Cash Plus The 60/40 Benchmark A Simple Risk Parity Benchmark Characteristics of the Risk Parity Benchmark Conclusion UPSIDE PARTICIPATION AND DOWNSIDE PROTECTION AND RISK PARITY PORTFOLIOS The New Holy Grail Three Ways to the Holy Grail Participation Ratios and PRD Participation Ratio and PRD of Risk Parity Portfolios 124

7 Contents ix Participation Ratios of Risk Parity Multi-Asset Portfolios Conclusion 128 CHARTER 6 History Lessons What Happened in 1994? Interest Rates Bond Returns Returns of Other Asset Classes Returns of Risk Parity Portfolios Is 2013 Like 1994? Conclusion Postmortem AFTER TAPER TANTRUM: AN IMPROVED OUTLOOK FOR RISK PARITY Historical Precedents What about Bonds? The Return of Diversification Conclusion Postmortem WAITING FOR THE OTHER SHOE TO DROP QE Tapering: The First Shoe Tantrum No. 2? Compare QE Tapering to the 2004 Rate Increases UST Yields Yield Curve Slopes Credit Spread Market Volatility Conclusion Postmortem IS US BECOMING JAPAN? United States Is Already Half Way There Living in a Low Growth and Low Inflation Environment Asset Allocation Implications Conclusion Postmortem 156

8 x Contents 6.5 RISK PARITY AND INFLATION Risk Parity and Inflation Protection Historical Analysis A Closer Look at the 1970s Conclusion 161 CHARTER 7. The "Wild West" of Risk Parity ARE RISK PARITY MANGERS RISK PARITY? What Is Risk Parity? A Style Analysis of Risk Parity Risk Allocations of Risk Parity Managers Return "Tests" Conclusion PREDICTING RISK PARITY MANAGERS' PERFORMANCE Summary Results of the Style Analysis Out-of-Sample Market Environment "Average" Risk Parity Manager Individual Risk Parity Managers Drawdown Prediction Conclusion "VALUE" OF STOP-LOSS INVESTMENT POLICIES Overcome Behavioral Biases When Does Stop-Loss Work? Characteristics of Asset Class Returns A Simple Stop-Loss Test So When Does Stop-Loss Really Work? Conclusion 186 CHARTER 8 Risk Parity Everywhere: Much of a Good Thing is a Great Thing "GO THE DISTANCE": A MORE GRANULAR APPLICATION OF RISK PARITY Concentration across the Country Dimension Concentration across the Sector Dimension Concentration across the Stock Dimension The Most Important Dimension to Address Conclusion 196

9 Contents xi 8.2 REACHING FOR YIELD: THE RISK PARITY WAY Why Bond Yields Are So Low? The Risk/Return Trade-Off of Reaching for Yield How to Increase Term Spread A Risk Parity Fixed-Income Portfolio Reaching for Yield the Risk Parity Way Conclusion RISK PARITY AS A GM HEDGE FUND Risk Parity as a Hedge Fund Strategy Beta Exposures of Global MacroHedge Funds GM Hedge Fund Replication and Risk Parity Portfolios Conclusion PENSION LIABILITIES AND RISK PARITY The Unhappiness in Pension Families Public Pensions: Finding That 7% Portfolio with Minimum Risk Corporate Pensions: Using Risk Parity in an Asset-Liability Framework Underfunded Corporate Pensions De-Risking, but How Conclusion 221 REFERENCES, 223 INDEX, 225