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management to help our
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formulate strategies, and
optimize performance.
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of investor behavior
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and indices to monitor
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market context.
Overview
The increasing liquidity and integration of global financial markets in recent decades has
made it more challenging than ever to construct diversified portfolios that deliver an
acceptable level of return.
The global financial crisis of 2008 and 2009 provided a stark and costly reminder that
diversification often disappears when we need it most. It also stimulated many investors to
take a fresh look at their asset allocation processes and their reliance on MPT in particular.
The Risk Parity framework has emerged as perhaps the most prominent alternative to
traditional MPT. While we commend its focus on risk and diversification, we argue that
Risk Parity suffers from some significant drawbacks. Notably, it is unclear whether the
factors that drove its past performance will persist going forward.
Risk factor analysis has also gained visibility over the past several years. Risk factor
analysis cannot change the fundamental opportunity set facing investors. However, it is a
powerful tool that can improve our ability to understand and communicate the inherent
risks of investing. It should be an integral component of the asset allocation process.
We present several innovations in MPT and demonstrate how they can be applied. These
innovations enable investors to incorporate multiple dimensions of risk, non-normal return
distributions, asymmetric preferences, within-horizon loss considerations, and regimespecific assumptions into the asset allocation framework.
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Risk Parity
Risk Parity calls for investors to allocate their portfolios such that each asset
class has an equal contribution to portfolio volatility. This calculation does not
require estimates of expected returns only volatilities and correlations.
Risk Parity portfolios almost always allocate more dollars to bonds than to
equities, and hence offer lower expected returns than most institutions require.
However, proponents argue that Risk Parity portfolios are better diversified than
equity-heavy portfolios and will therefore generate higher Sharpe ratios.
9.0%
8.5%
Expected return
8.0%
7.5%
7.0%
6.5%
6.0%
Minimum-risk portfolio:
5% stocks
5.5%
5.0%
0%
5%
10%
15%
20%
25%
A digression on sigma
A 1-sigma event is a one standard deviation move, a 2-sigma event is a two
standard move, and so forth.
When investors describe events using sigma, they are implicitly assuming that
returns follow a normal, bell curve distribution.
In the summer of 2007, a high-profile hedge fund announced that it had experienced
two 25-sigma events in a row.
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Source: Dowd, K., J. Cotter, C. Humphrey, and M. Woods. How Unlikely Is 25-Sigma? The Journal of Portfolio
Management, Summer 2008.
12
Source: Dowd, K., J. Cotter, C. Humphrey, and M. Woods. How Unlikely Is 25-Sigma? The Journal of Portfolio
Management, Summer 2008.
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Full-Scale Optimization
Full-Scale Optimization (FSO) is a
numerical portfolio construction
technique that relies on genetic search
algorithms to maximize utility based on
an investors unique preferences.
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Asset classes*
Asset class
Index
Start date
US equities
January 1970
International equities
January 1970
Emerging equities
January 1988
US government bonds
January 1973
US corporate bonds
January 1973
Barclays US HY Composite
July 1983
Inflation-linked bonds
March 1997
Commodities
January 1970
Real estate
December 1977
Private equity
March 1986
*All asset class data is monthly with the exception of real estate and private equity which are quarterly.
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Risk factors
Factor
Description
Details
Start date
Equity premium
February 1973
EM premium
January 1988
Interest rates
February 1973
Term premium
July 1976
Credit spread
February 1973
Breakeven inflation
February 1997
Currency
Price return
February 1973
Oil
Price return
June 1983
Gold
Price return
February 1973
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Five-asset portfolio
19
Jun-10
Jun-08
Jun-06
Jun-04
Jun-02
Jun-00
Jun-98
Jun-96
Jun-94
Jun-92
Jun-90
Jun-88
Jun-86
Jun-84
Jun-82
Jun-80
Jun-78
-0.4
Equity Premium
Term Premium
Credit Premium
EM premium
US Dollar
Gold Bullion
Unexplained
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Expected returns: US Equity 8%, International Equity 9%, US Govt Bonds 4%, US Corp Bonds 5%, Commodities 5%
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0.5
0.5
-0.5
-0.5
1.4
1.4
1.4
1.4
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23
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construct
optimal
unconditioned
portfolio
high
construct
eventconditioned
portfolio
low
high
low
Inflation-linked bonds
8.9%
Unconditioned portfolio
Conditioned portfolio
13%
Commodities
6.2%
10.8%
11%
9.6%
Short government bonds
4.3%
-2.7%
International equity
-3.9%
-3.9%
9.3%
8.6%
9%
7%
5%
3%
1%
Domestic equity
-8.8%
-1%
0%
5%
Full sample
Inflationary sample
10% 15%
*Results cover July 1983 through March 2011. Multi-risk Full-Scale Optimization imposes absolute and relative kinks at -2% and left slopes of 10. We use
the 80th percentile next-month inflation rate to partition the samples. Results are averages for 1,000 runs. Expected returns: Domestic equities 8%,
International equities 9%, Long government bonds 4%, Short government bonds 3%, Corporate bonds 5%, Inflation-linked bonds 4%, Commodities 5%.
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References
Adler T. and M. Kritzman. Mean-Variance versus Full-Scale Optimisation: In and Out of Sample.
Journal of Asset Management, Vol. 7, No. 5.
Ang, Andrew. The Four Benchmarks of Sovereign Wealth Funds. Columbia Business School and
NBER, September 2010.
Bhansali, Vineer. Beyond Risk Parity. The Journal of Investing, Vol. 20, No. 1 (Spring 2011).
Chaves, D., J. Hsu, F. Li, and O. Shakernia. Risk Parity Portfolios vs. Other Asset Allocation Heuristic
Portfolios. The Journal of Investing, Vol. 20, No. 1 (Spring 2011).
Chow, George. Portfolio Selection Based on Return, Risk, and Relative Performance. Financial
Analysts Journal, Vol. 51, No. 2 (March/April 1995).
Chua, D., M. Kritzman, and S. Page. The Myth of Diversification. The Journal of Portfolio
Management, Vol. 36, No. 1 (Fall 2009).
Inker, Ben. The Dangers of Risk Parity. The Journal of Investing, Vol. 20, No. 1 (Spring 2011).
Kritzman, M. and D. Rich. The Mismeasurement of Risk. Financial Analysts Journal, Vol. 58, No. 3
(May/June 2002).
Kritzman, M., S. Page, and D. Turkington. Regime Shifts: Implications for Dynamic Strategies.
Working Paper, May 2, 2011.
Kritzman, M. and Y. Li. Skulls, Financial Turbulence, and Risk Management. Financial Analysts
Journal, Vol. 66, No. 5 (September/October 2010).
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