A Different Take On Risk Parity

Risk parity has always intrigued me but I've always thought the plain vanilla way to implement it is either hard to do or not that good of a strategy with the results of the Risk Parity ETF offered up as Exhibit 1, although it did well in 2024.

Risk parity is about weighting the holdings such that their respective contributions of risk to the portfolio are the same. A portfolio of an S&P 500 fund and T-bills would have just a small portion in the S&P 500 and the vast majority in T-bills. The generic implementation is to leverage up on debt to balance out the equity exposure similar to what RAPR does but it includes commodities too. The block I was having is that it must be used in simple stock/bond portfolios but that's not the case. Playing around more with Finominal helped me figure that out. FTR, I have no affiliation with Finominal, this is more like getting a new toy to play with. 

Finominal has a portfolio optimizer that lets you optimize for various things including risk parity. In playing around with some of the others, I didn't find anything useful yet but I think I did when optimizing for risk parity. A couple of different ideas to experiment with, here's the first one;

The results of the two are very different. I threw in VBAIX for context;

Portfolio 1 has much better returns with just a little more volatility than VBAIX while Portfolio 2 had 80% of VBAIX' CAGR with less than half the downside and a 1/3 of the volatility. 

Here's another one;

And again compared to VBAIX;

In the second one, Portfolio 1 looks good of course but Portfolio 2 is more interesting, the return equals VBAIX but with less than half the volatility and smaller drawdowns. I believe the reason that the risk parity optimization gives interesting results is that the intuitive versions don't use plain vanilla bonds to manage/offset equity volatility. Putting in 60% SPY/40% AGG into the risk parity optimizer tells us to put 22% in SPY and 78% in AGG which decade to date has compounded three basis points less than inflation. SPY/AGG is not the right input for this exercise. 

The utility of the approach we took today can be a path to cracking the 75/50 code (targets 75% of the upside with only 50% of the downside). 

A cautionary note is that the optimization process ignores the risk of having enormous weightings to one fund like 47% in APHPX or 46% in FLXIX. That much in one liquid alt?

From there, anyone interested in this would need to add more funds and spend some time adjusting the weighting. No matter how great some alternative strategy/fund might be or how glorious the backtest is, it will take a turn being a poor performer and a huge weighting when that happens is an unforced error waiting to happen.

One final item is from today's ETF IQ show which included a segment on the Hedgeye Fourth Turning ETF (HEFT). The idea is to position for big changes in how things are going now and the manager said the strategy has a ten year time horizon. HEFT is a multi-asset fund that includes long/short equity. 

I really don't know anything about the fund but the reason to bring it up at all is differentiation. We've used that word several times lately and HEFT is a good example of what that looks like.

It looks nothing like 60/40, rarely looks like the Permanent Portfolio and occasionally looks similar to other long/short equity. Who knows if that can persist but it has been a good example of the concept thus far. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.