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Introducing the S&P Risk Parity Indices
How important is diversification across time and asset classes?
By Tianyin Cheng, Director, Strategy & ESG Indices, Berlinda Liu, Senior Director, Global Research & Design, and Vinit Srivastava, Managing Director, Head of Strategy and ESG Indices, S&P Dow Jones Indices
Risk parity, at its core, is an argument about the importance of diversification – across time and across asset classes. There are various ways risk parity strategies can be implemented, making it difficult to define a proper benchmark for risk parity funds and strategies. The S&P Risk Parity Index Series uses a transparent, rules-based methodology to construct risk parity benchmarks that are easy to understand and replicate. The historical performance of the S&P Risk Parity Indices reveals that risk parity did not outperform a traditional 60/40 portfolio in all economic environments; however, it could provide a potentially smoother path of returns due to the inherent risk diversification. Benefiting from a material allocation to a broad basket of commodities, the S&P Risk Parity Indices could also offer a hedge to inflation that cannot be found in a 60/40 portfolio, according to the authors of this paper.
What’s behind risk parity?
The principles behind risk parity relate to answering a deceptively straightforward question: What is diversification? Traditionally, investors have allocated their capital among multiple asset classes to achieve diversification, such as the 60/40 equity/bond blend. Such an approach leads to a disproportionate allocation of risk across asset classes, with equities taking up most of the risk allocation.
A risk parity strategy aims for balanced risk contribution from all asset classes. The authors of this paper understand that asset class returns are generally proportional to the risk taken (according to Capital Market Pricing Model) and that a diversified portfolio consisting of relatively uncorrelated assets may reduce risk without foregoing return. Different economic cycles also expose different asset classes to different levels of risk. Risk parity strategies take these factors into account and aim to balance risk contribution from a mix of assets and apply leverage to the overall portfolio, which can help to meet the twin challenges of achieving higher returns, while reducing risk in a diversified portfolio.
Since the first risk parity fund – Bridgewater’s All Weather fund – premiered in 1996, many investment companies have begun offering risk parity funds to their clients, especially in the aftermath of the global financial crisis in 2008. Such strategies lacked an appropriate benchmark, and most investors used a traditional 60/40 mix to benchmark the returns of risk parity funds. The issue that can arise from this is that most of these benchmarks do not reflect either the construction or the risk/return expectations from such strategies. In addition, risk parity strategies have been largely in the domain of active management, even though these strategies are systematic and lend themselves well to passive implementation.
The purpose of the S&P Risk Parity Indices is to provide appropriate benchmarks for risk parity and to provide an alternative to investors who are looking for a passive investable solution. The benchmarks also reflect the risk/return characteristics of funds offered in this space. Key advantages of these indices include the following.
Transparent Methodology: As with every index published by S&P Dow Jones Indices (S&P DJI), the index methodology is available publicly online.
Investable: These indices are constructed bottom up using liquid futures instruments. S&P DJI publishes the allocation of the indices to each of these instruments daily, along with the pro-forma allocation prior to the roll of those contracts. S&P DJI chooses liquid, representative contracts in the index design in order to target investability. In addition to be being investable, the index returns are fully replicable for similar reasons. Fund-based benchmarks are not investable by design, nor are they replicable.
No Survivorship Bias: A fund-based benchmark, which is what was previously available in the market, is subject to survivorship bias.