Risk Parity Portfolio vs. Other Asset Allocation Heuristic Portfolios

OMID SHAKERNIA is a senior researcher at Research Affiliates, LLC, in Newport Beach, CA. [email protected] Traditional strategic asset allocation theory is deeply rooted in the mean–variance portfolio optimization framework developed by Markowitz [1952] for constructing equity portfolios. However, the mean–variance optimization methodology is diff icult to implement due to the challenges associated with estimating the expected returns and covariances for asset classes with accuracy. Subjective estimates on forward returns and risks can often be inf luenced by behavioral biases of the investor, such as over-estimating expected returns due to the recent strong performance of an asset class or under-estimating risk due to personal familiarity with an asset class. Empirical estimates based on historical data are often far too noisy to be useful, especially if risk premia and correlations for asset classes are time varying. Additionally, the possibility of “paradigm shift” in the capital market makes historical data far less relevant for forecasting the future evolution of asset returns. This last concern is especially relevant today given the hypothesis on a “new normal” for the global economy postulated by Gross [2009]. The challenges in the implementation of Markowitz’s portfolio optimization have led to a wide gap between the theory of the practice and the practice of the theory. In practice, institutional pension portfolios largely take on a 60/40 equity/bond allocation, with alternative asset classes, at the margin, garnering only modest weights. It is unlikely that this portfolio posture falls out of an exercise in constrained portfolio mean–variance optimization; rather it is a hybrid child of legacy portfolio practice and return targeting. Using historical realized risk premia to guide our capital market return expectations, assuming a 9.0% equity return and a 6.5% bond returns, the 60/40 portfolio conveniently achieves the 8% portfolio return target that is common to most pension funds. As more asset classes, such as real estate, commodities, and emerging market securities, are added to the investment universe, weights are reallocated from stocks and bonds modestly to these alternative assets. Most pension funds hold a 60/40 equity/bond variant portfolio despite the significantly larger universe of investable asset classes. Undoubtedly, these incremental allocations improve portfolio mean–variance eff iciency by improving diversification; however, it is also likely that more-optimal asset allocation methods or heuristics can be created.