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Understand. Act.
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4 Dynamic risk parity a smart way to manage risks Using an example to illustrate the benefits of risk parity Risk parity adjusts to the current market environment The advantage of volatility targets Dynamic Risk parity a necessary addition 5
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10 Estimating and managing the risks 11 Longer-term benefits of the risk parity approach 12 Making the best possible use of diversification 14 Thats all very well for the past, but what about the future? 15 Understand. Act.
Imprint
Allianz Global Investors Europe GmbH Bockenheimer Landstr. 42 44 60323 Frankfurt am Main Global Capital Markets & Thematic Research Hans-Jrg Naumer (hjn) Dennis Nacken (dn) Stefan Scheurer (st)
Dr. Timo Teuber, CFA, is a Portfolio Manager in the Multi-Asset Protection Team at Allianz Global Investors. He has been managing capital preservation portfolios for institutional clients since 2011. Dr. Teuber is responsible for developing and managing the dynamic risk parity strategy that the team has been employing successfully since 2012. He is also responsible for the conceptual design of cross-asset investment models for making efficient use of risk budgets. Dr. Teuber joined Allianz Global Investors in 2009. While completing the Global Graduate Programme, he worked as a member of various teams in Germany and the USA.
Risk parity is an investment approach aimed at spreading risk evenly (parity = the state or condition of being equal). In a conventional 50 / 50 balanced portfolio, the equal balance between equities and bonds only relates to market value. However, since equities are generally exposed to greater risk than bonds, they account for a larger share of the portfolio
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risk and dominate the risk profile and the return to a considerable extent. By contrast, the exposure associated with equities is reduced in favour of bonds in a risk parity portfolio, such that each asset class contributes one half to the portfolio risk. The reduction of overall risk is an additional side effect of this approach.
To enable fair or comparable analysis of the income side, the different portfolios are brought to the same risk level. Considering a bond investor who wants to accept a specific volatility (4 % in this example), the investor has several alternatives: instead of allocating 100 % to bonds, he can either invest 48.5 % in the 50 / 50 balanced portfolio, or 88.4 % in the risk parity portfolio, or 25 % in equities (see figure 2). In each case, the remaining money would be allocated to risk-free for example money market investments. To identify a starting point for the earnings side, the longterm expected return for bonds is fixed at 1.5 % p. a. and for the money market at 0.1 % p. a. The latter is fairly conservative, given the current yield curve and the historical excess returns of typical bond portfolios vis--vis the money market.
Risk Parity
Equities 20 % Bonds 80 %
Bonds 0.5 % Risk allocation Equities 7.8 % Bonds 2.3 % Equities 2.3 %
The top row shows the market value allocations for the 50 / 50 balanced portfolio (left) and the risk parity portfolio (right). The bottom row shows the risk allocations for both portfolios with the height being indicative of the total risk. A classic approach first determines the market value allocation, from which the risk allocation is then derived. The risk parity (or, more generally, risk budgeting) approach determines the risk allocation, from which the market value allocation is then derived. Past performance is not a reliable indicator of future results. Source: Allianz Global Investors Capital Markets & Thematic Research, December 2013
50/50 Balanced Portfolio Money Market 11.6 % Money Market 51.5 % Equities 24.3 %
Risk allocation
Bonds 4.0 %
Equities 4.0 %
Past performance is not a reliable indicator of future results. Source: Allianz Global Investors Capital Markets & Thematic Research, December 2013
Based on this assumption, the 50 / 50 balanced portfolio will only demonstrate a higher expected return than the risk parity portfolio if the expected return on equities is more than 10 %. This means that the risk premium for equities must be at least 8.5 %, which is fairly high by historical comparison. In the event that equities demonstrate an expected return of exactly 10 %, the 25 % allocation to equities (with the remaining 75 % invested on the money market) can be expected to return just 2.58 % p. a. In spite of the extremely high risk premium for equities, the expected return for the diversified risk parity portfolio is greater, at 2.84 % p. a. As such, even if the outlook for equities looks positive, investors should still consider the diversified investment. After all, if the optimistic prospects for equities fail to materialize, a diversified investment should offer clear advantages. For some investors, the 30-year bond rally is the only reason why the risk parity strategy succeeds. In the example above, however, the earnings expectations are much higher for equities than for bonds. Nevertheless, a greater (risk-adjusted) return can be expected with the diversified risk parity allocation than from the best asset class (equities). The real reason why the strategy can be favorable is therefore not the performance contribution but the diversification effect of bonds. The potential inherent in this diversification effect is often underestimated. Which implies: the
more (independent) asset classes that are included, the more potential the approach offers.
A look at the risk allocation of the fixed 20 / 80 allocation (the risk parity portfolio in moderate market conditions) shows how important adjustments are. Equities only account for 36 % of the risk in a good market environment, but more than 60 % in bad market conditions. Additionally the overall risk increases significantly from 4 % to around 5.12 %. Both the risk and return profiles deteriorate over both scenarios: Volatility increases to around 4.6 % while the return drops to approx. 3.2 %. Bearing in mind the observation that expected returns increase in a good market environment and decrease in poor market conditions, the risk-adjusted return improves, however, increasingly. The disadvantage of clinging to the fixed allocation is therefore clearly visible: The contribution to risk by the less attractive asset class rises in both scenarios; whether investors are always aware of this effect and, above all, really want it, is probably questionable. Strategic asset allocation defined as contributions to risk as is the case with risk parity therefore offers potential benefits, since exposure to less attractive asset classes is pro-actively reduced and increased to attractive asset classes.
Money Market 15.1 % Investment with a 4 % target volatility Equities 14.1 % Bonds 70.7 %
Risk Parity allocation for various equity market conditions (bad environment 20 % volatility, moderate environment: 16 % volatility, good environment: 12 % volatility) and a constant bond volatility of 4 %. Upper line shows Risk Parity allocation with full investment and the bottom line shows risk parity allocation with a constant volatility of 4 %. In this case the equity investment part increases when market conditions get better and the money market investment decreases. Past performance is not a reliable indicator of future results. Source: Allianz Global Investors Capital Markets & Thematic Research, December 2013 7
moderate scenario. Investors may, however, not reap the benefits of higher returns from accepting this greater risk as very clearly illustrated by the fixed 20 / 80 allocation since the expected return is constant in all three scenarios. As such, investors are rewarded with higher risk-adjusted returns potential when volatility remains constant over the period. Added to which, risk-adjusted returns deteriorate measured by the Sharpe Ratio1 in poor market conditions purely as a result of the increased risk, even if the returns themselves remain constant, since the increasing volatility (the denominator of the equation) decreases the Sharpe Ratio. For an investment approach with a volatility target to become less attractive, however, the risk-adjusted returns would first have to rise considerably in poor market conditions, meaning that the expected returns would have to increase even more strongly. The potential advantage of a volatility target is further enhanced by the observation that expected returns tend to increase in a good market environment and decrease in poor market conditions.
earnings is not always the best course of action. A healthy amount of targeted active management is, however, advisable. As such, risk parity can be seen as an anchor portfolio for taking advantage of the diversification effect. Active opinions are then built in around this portfolio. Asset classes with positive (negative) prospects are assigned a higher (lower) risk contribution in an effort to enable promising opportunities to be exploited and unattractive risks avoided. Additionally a further indicator such as a market cycle indicator could offer an objective, transparent and understandable means of integrating active opinions relating to any asset class into the concept. The indicator could be based solely on historical prices and should include a trend and trend reversal component. The concept behind such a market cycle indicator: Capital markets frequently pursue longer-term trends that are measured by the pro-cyclical trend component. However, the markets often tend to exaggerate, which is then mapped by the anti-cyclical trend reversal component (see figure 4). Since the magnitude of the trends differs for each asset class, the value of the market cycle indicator can also differ. This exemplary method should therefore support the intelligent management of risk contributions. Greater risks are taken in those markets that promise disproportionately high expected returns. By contrast, risks are actively reduced in markets with negative prospects.
The Sharpe Ratio measures the ratio of the expected excess return, i. e. expected return minus the risk-free return, against the volatility.
1
Price
Time Increase Reduce overover-weight weight Increase overweight Increase Reduce overover-weight weight Increase overweight
Price
Time
Active weight
Active weight
Past performance is not a reliable indicator of future results. Source: Allianz Global Investors Capital Markets & Thematic Research, December 2013
Macro-economic factors can also be tied in such an indicator. For example, bonds quite clearly differ strongly in terms of expected return, depending on whether interest levels are high or low, and interest rates are rising or falling. Fundamental factors, such as economic growth or inflation, obviously play a
key role in influencing return expectations for individual asset classes. As such, regimedependent2 assessments can add value (see Table 1). Based on these assessments, investors can actively deviate from this risk parity in order to ensure the best possible allocation for each and every market environment.
Statistical models with regime changes can model different states (e. g. bad, good or moderate market conditions). The model parameters can be different in each phase.
Low
Normal
High
Low
Normal
High
Regime-dependent risk premium assessment of US equities, commodities and US bonds. Since an assessment that disregards economic growth and inflation reveals clear differences affecting both the regime and asset classes, active asset allocation can optimize the generation of risk premium earnings. Historical simulation between 31/12/1970 30/12/2013, Indices used: S&P 500, S&P GSCI Total Return CME, Federal Reserve US Treasury Note Constant Maturity Not Averaged 10 Year, 3-Month Treasury Bill: Secondary Market Rate, US GDP, US Industrial Production, US Capacity Utilization, US CPI-Urban, US CPI ex Food & Energy, US PCE Price Index less Food & Energy, US PPI Finished Goods, US PPI Intermediate Goods less Foods & Feeds, US PPI Crude Materials Past performance is not a reliable indicator of future results. Source: Allianz Global Investors Capital Markets & Thematic Research, December 2013 9
is that the estimates more closely resemble reality, although a larger data pool must be available to produce good assessments. Table 2 is an example illustrating the risks for US equities, US bonds and commodities, depending on economic growth and inflation. The advantage of volatility is that just a few data points are required to produce a good assessment. Thus historical simulations can stretch further back into the past and therefore be much more meaningful. The past has, however, proven that returns are anything but normally distributed: Many asset classes (especially bonds) demonstrate an asymmetric return distribution, that is moderate positive returns occur frequently and losses are usually rare, but severe. Also so-called fat tails, i. e. extreme events occur more frequently than would normally be expected. Risk management should, of course, consider precisely these non-normal attributes of returns to ensure that extreme events, such as witnessed in 2008, do not result in losses that investors are no longer able to shoulder. Added to which, investors must consider whether they only want to take account of price risks, or other risks as well, such as liquidity risks. The extreme example of 2008 shows that many asset classes were characterised by low liquidity. Sales were therefore only possible at severe discounts. Historical
Volatility
Low
Normal
High
Low
Normal
High
Regime-dependent risk assessment of US equities, commodities and US bonds. An assessment that disregards economic growth and inflation reveals clear differences. Since the risks differ in the individual regimes, the risk parity allocation will also differ. Historical simulation between 31/12/1970 30/12/2013, Indices used: S&P 500, S&P GSCI Total Return CME, Federal Reserve US Treasury Note Constant Maturity Not Averaged 10 Year, 3-Month Treasury Bill: Secondary Market Rate, US GDP, US Industrial Production, US Capacity Utilization, US CPI-Urban, US CPI ex Food & Energy, US PCE Price Index less Food & Energy, US PPI Finished Goods, US PPI Intermediate Goods less Foods & Feeds, US PPI Crude Materials Past performance is not a reliable indicator of future results. Source: Allianz Global Investors Capital Markets & Thematic Research, December 2013 10
simulations show, however, that even a risk management approach that assumes normal returns can produce very good risk reduction and ensure that maximum loss targets are not undercut. Investors can therefore generate an asymmetrical return profile, i. e. limit losses and let profits grow. The question of whether, and especially to what extent, risk management should be adopted, differs from one investor to the next.
Sharpe Ratios (1/1970 12/2013) Historical simulation between 31/12/1970 30/12/2013, Indices used, Equities = MSCI USA Daily TR Gross USD, Government Bonds = Federal Reserve US Treasury Note Constant Maturity Not Averaged 10 Year, Commodities = S&P GSCI Total Return CME, Money Market = Treasury Bill Secondary Market 3 Month
0.33
0.28
1.0 0.8 0.6 0.4 0.2 0.0 Equities Government Commodities Dynamic Risk Parity Bonds 0.07 0.13 0.62 0.72
Sharpe Ratios during time periods strongly favoring Commodities (1/1970 12/2013)
Historical simulation between 31/12/1970 30/12/2013, Indices used, MSCI Daily TR Gross USA USD, Federal Reserve US Treasury Note Constant Maturity Not Averaged 10 Year, S&P GSCI Total Return CME, Treasury Bill Secondary Market 3 Month; dynamic risk parity (*risk parity and market cycle indicator but without risk management) Past performance is not a reliable indicator of future results. Source: Allianz Global Investors Capital Markets & Thematic Research, December 2013 11
ment bonds (incl. inflation-linked bonds) and credit (all other bonds) asset classes clusters also demonstrates risk parity. Last but not least, the allocation to the growth (equities, and high-yield and emerging market bonds), inflation (commodities, REITs and inflation-linked bonds) and recession (all other bonds) clusters also demonstrate an adequate exposure to the business cycle phases. In addition to the classic risk parity clusters of equities and bonds, therefore, inflation and credit are included as themes with an aim to ensure strategically good positioning looking forward. Due to the availability of data, such a broad portfolio can unfortunately only be analysed from 2001 onwards till the end of 2013. Historical simulation produces a remarkable result: Despite including asset classes with below-average performance, even the standard risk parity approach (without active asset allocation) was in the past capable of generating an identical return with the same risk
Figure 7: Strategic Risk Allocation of the broad Dynamic Risk Parity Strategy
Growth Spread Emerging Markets Bonds High Yields Emerging Market Equities Equity Global Equities Global Reits Commodities Defensive Spreads Corporates Covered Bonds European Bonds Government
Global ex Euro Bonds Euro Inflation Bonds Global Inflation Bonds Growth & Inflation Inflation Linker
Indices used for historical simulation: Global Equities = MSCI World EUR, Emerging Markets Equities = MSCI Emerging Markets Daily EUR, Commodities = Dow Jones-UBS Commodity Index Euro Total Return, Global REITs = FTSE EPRA / NAREIT Developed Index, High Yields = Barclays Pan-European High Yield Total Return Index Value Unhedged EUR, Emerging Markets Bonds = JPMorgan EMBIG Hedged in Euro, Corporate Bonds = Barclays EuroAgg Corporate Total Return Index Value Unhedged EUR, Covered Bonds = Barclays EuroAgg Securitized Total Return Index Value Unhedged EUR, Euro Inflation Bonds = Barclays Euro Govt Inflation-Linked Bond Index All Maturities, Global Inflation Bonds = Barclays World Government Ex-Euro Inflation-Linked Bond Index Hedged EUR, Global ex Euro Bonds = Barclays Global Aggregate Ex Treasury (EUR) Total Return Index Value Hedged EUR, European Bonds = Barclays Euro Agg Treasury Aaa Total Return Index Value Unhedged EUR, Global Bonds = Barclays Global Agg Total Return Index Value Hedged EUR, Money Market = Euribor 1 Month ACT / 360 Past performance is not a reliable indicator of future results. Source: Allianz Global Investors Capital Markets & Thematic Research, December 2013
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exposure as government bonds, which were the best asset class in the period in question. Active asset allocation using a market cycle indicator was even able to raise the average return by about 65 base points p. a. without increasing the risk. Furthermore, the realised Figure 8: Risk Parity in all dimensions
Risk
annual losses could be limited to less than 5 % with the aid of risk management while at the same time the average return increased due to the severe slump in 2008 (see first three lines of Table 1).
Fundamental
Global Growth
Global Defensive
Nominal Growth
Risk on
Equity
Risk parity from all perspectives: Parity-driven breakdown of the asset classes in Risk on and Risk off clusters. Paritydriven assignment of asset classes by sensitivity for various economic phases (nominal growth, recession and inflation). Parity-driven breakdown of the asset classes credit, equities and government bonds. The resulting investment themes Growth spread, Defensive spread, Equities, Government bonds, Growth & Inflation and Inflation linker are all based on parity considerations. Past performance is not a reliable indicator of future results. Source: Allianz Global Investors Capital Markets & Thematic Research, December 2013
Global Bonds
2.27 %
Results of historical simulation from January 2001 to end December 2013 for global bonds, risk parity 1.0* (*with volatility target on government bond volatility); dynamic risk parity ** (**with volatility target on government bond volatility and market cycle indicator but without risk management) and dynamic risk parity (with risk management: maximum loss target of 5 % over the course of one year). Past performance is not a reliable indicator of future results. Source: Allianz Global Investors Capital Markets & Thematic Research, December 2013
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Thats all very well for the past, but what about the future?
Expectations can be defined for the different asset classes of the dynamic risk parity strategy based on expectations for the single assets returns and risks, which can be derived from current market data using scenario anal-
ysis and Monte Carlo simulation. Generally speaking, returns potential cannot be raised without increasing risk. Based on the current allocation, the dynamic risk parity strategy demonstrates relatively attractive risk / return profile compared to all other asset classes (see figure 9).
Commodities
Dynamic Risk-Parity Corporate Bonds Covered Bonds Pfandbriefe Inflation linked bonds Government bonds US Government bonds EUR Money Market (1m EUR) 5% 10 %
15 %
20 %
25 %
Expected returns and volatilities for various asset classes and 1-month Euribor money market rates. Expectations for the dynamic risk parity strategy based on an asset allocation example. Past performance is not a reliable indicator of future results. Source: Risk lab Allianz Global Investors Capital Markets & Thematic Research, December 2013
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Understand. Act.
There are various reasons why the risk parity strategy appears to have potential. The key driver of success is, however, clearly the diversification effect that enables a good ratio of return to risk by intelligently allocating risk. Since risk parity adjusts to current market conditions, timely assessment of the risks and appropriate adjustments are crucial. Linking the investment approach to volatility targets can further enhance the possibility of additional earnings. That said, active manage-
ment is enormously important, even for this investment approach, to enable conscious deviations from the anchor portfolio so as to enhance returns and reduce risks. Very longterm historical simulations indicated that the risk parity approach appeared to be superior to static allocations, even over a complete interest rate cycle. A very broad investment universe can, moreover, take even better advantage of the diversification effect. Timo Teuber
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Do you know the other publications of Allianz GI Global Capital Markets & Thematic Research
Risk. Management. Reward. Smart Risk investing in times of financial repression Strategic Asset Allocation Managing Risk in a time of Deleveraging Active Management The New Zoology of Investment Risk Management Constant Proportion Portfolio Insurance (CPPI) Portfolio Health Check: Preparing for Financial Repression Financial Repression Shrinking mountains of debt International monetary policy in the era of financial repression: a paradigm shift Financial Repression and Regulation: Paradigm Shift for Insurance Companies & Institutions for Occupational Retirement Provision Silent Deleveraging or debt haircut? that is the question Financial Repression A silent way to reduce debt Financial Repression It is happening already EMU You can find our wide-ranging supply of publications on the euro on our Market Insights section Bonds Duration Risk: Anatomy of modern bond bear markets Emerging Market currencies are likely to appreciate in the coming years High Yield corporate bonds US High-Yield Bond Market Large, Liquid, Attractive Credit Spread Compensation for Default Corporate Bonds Why Asian Bonds? Behavioral Finance Reining in Lack of Investor Discipline: The Ulysses Strategy Overcoming Investor Paralysis: Invest more tomorrow Outsmart yourself! Investors are only human too Two minds at work Dividends Dividend Strategies and Troughs in Earnings Revisions Dividend Stocks an attractive addition to a portfolio Dividend strategies in an environment of inflation and deflation High payout ratio = high earnings growth in the future Changing World Renewable Energies Investing against the climate change The green Kondratieff Crises: The Creative Power of Destruction Demography Pension Discount rates low on the reporting dates IFRS Accounting of Pension Obligations Demographic Turning Point (Part 1) Pension Systems in a Demographic Transition (Part 2) Demography as an Investment Opportunity (Part 3)
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Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The hypothetical performance and simulations shown are for illustrative purposes only and do not represent actual performance; they are not a reliable indicator for future results. Back-testings and hypothetical or simulated performance data has many inherent limitations only some of which are described as follows: (i) It is designed with the benefit of hindsight, based on historical data, and does not reflect the impact that certain economic and market factors might have had on the decision-making process, if a clients portfolio had actually been managed. No back-testings, hypothetical or simulated performance can completely account for the impact of financial risk in actual performance. (ii) It does not reflect actual transactions and cannot accurately account for the ability to withstand losses. (iii) The information is based, in part, on hypothetical assumptions made for modeling purposes that may not be realized in the actual management of portfolios. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in achieving the returns have been stated or fully considered. Assumption changes may have a material impact on the model returns presented. The back-testing of performance differs from actual portfolio performance because the investment strategy may be adjusted at any time, for any reason. Investors should not assume that they will experience a performance similar to the back-testings, hypothetical or simulated performance shown. Material differences between back-testings, hypothetical or simulated performance results and actual results subsequently achieved by any investment strategy are possible. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission (SEC); Allianz Global Investors Europe GmbH, an investment company in Germany, authorized by the German Bundesanstalt fr Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Hong Kong Ltd. and RCM Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; and Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.
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