Is Risk parity to blame for the most recent spike in volatility?

Senior Fund Managers Peter Schlagbauer and Thomas Bichler managing Active Risk Allocation Funds at Raiffeisen Capital Management* try to separate myths from fact to this assertion, based on many misconceptions and some elements of truth. Three important aspects are attached to this kind of criticism concerning risk parity funds.

What is generally expected from risk parity approaches?
There is a certain degree of disappointment with risk parity funds because of their claim to mitigate risk through diversification and because of the most recent underperformance versus bond/equity portfolios. First of all, one should be aware that this claim of risk diversification is based on a long term horizon. Indeed, the basic idea of combining, for example, not only equities and government bonds, but also real assets such as commodities and inflation linked bonds as well as credit assets such as emerging markets and corporate bonds in a balanced risk approach, is done to reap the LONG TERM diversification effects across different economic environments or scenarios. Secondly, risk parity (diversified) portfolios can and will underperform concentrated portfolios for extended periods, but in the long term offer better return/risk rewards.

How is risk estimated?
Any investor or asset manager – be it quant or discretionary – has to explicitly or implicitly think about the risk he takes in a portfolio. The methods used to estimate risk can range from daily short term data to more static long term estimates, as well as from highly sophisticated forecasting models1 to ‘simple backward looking’. The point is that ANY investor who tries to control short term risk by estimating the risk based on short term data will – other things being equal – react to a rise in volatility of a certain asset by selling the asset. To have risk parity funds at the centre of this criticism is especially surprising, considering the fact that prominent providers of risk parity solutions do NOT base their risk data on short term data but on long term risk data and tend to BUY assets after significant downside movements because of rebalancing their reduced weights to the target weights.

How do investors react to a fall in prices?
It is not only quant oriented short term investors (that is, CTAs or hedge funds) that use momentum or trend following strategies, but also a lot of other professionals (just think about the popularity of momentum factors across asset classes) and retail investors that are chasing the markets and reinforcing sell-offs. A purely passive risk parity strategy will react to higher volatility by selling assets and therefore exhibits momentum behavior, too. Strategies focusing on long term forecasts for risk estimates, especially when combined with valuation factors, act, contrary to the criticism, even in an countercyclical way.«

Innovative Multi-Asset-Solutions since 1998
Managing Multi Asset portfolios is a core competence at Raiffeisen Capital Management*. In April 2008, Peter Schlagbauer and his colleagues have integrated Active Risk Allocation as a starting point of their investment process for two strategies. The first strategy targets high long-term risk-adjusted returns. The second strategy uses asymmetric risk overlays in addition with the goal of reducing significant drawdowns. The two strategies’ performance proves the team's ability to deliver strong long-term returns.

* Raiffeisen Capital Management stands for Raiffeisen Kapitalanlage-Gesellschaft m.b.H.
 1 A search at the ‘social science research network’ www.ssrn.com for the keywords joined usage of ‘volatility’ and ‘models’ in title of the papers in the library yields 384 papers as of Nov 7, 2015.