Risk parity strategies have become extremely popular in the marketplace in the last few years. Such strategies have been commonplace in a multi-asset framework. We investigate the possibility of such a strategy within the fixed income universe and the necessary attributes of the underlying assets to have a sensible implementation of such a strategy.
Market capitalization based strategies are the bedrock of fixed income investment. But they give larger weights to more indebted issuers in portfolios. Risk parity strategies would move away from market capitalization to a volatility-based measure of asset allocation. It should be noted that both measures have their own pros & cons. Effectively, we would move away from “more debt means more weight” framework to a “market risk is all that matters” framework. Moreover, risk parity strategies does not promise outperformance in all market cycles over market capitalization based strategies. Instead, it attempts to equalize risk contribution from individual portfolio constituents. For example, an asset with low volatility and low market capitalization will see its allocation pushed up in a risk parity framework. Whether this allocation, which would be an active position vs. the market cap benchmark, is a winning trade is another matter.
We apply the risk parity framework to Citigroup’s EGBI index that comprises government issues from EMU countries only.
The result we find is that there is very little benefit of using risk parity strategies prior to 2009. Why is that? It is mainly due to the fact that there is very little differentiation among Euro countries. This can be visually confirmed by the two charts below. The average correlations have been close to 1 between the countries up until 2009 and the volatility has been pretty closely tied to one another with very little differentiation and risk parity does not add value here.
What happens from 2009 is that there is volatility introduced into the market due to the Euro crisis. We saw correlations between Core and periphery breakdown while also seeing volatility in the periphery spike up. The risk parity strategy then responded by increasing allocations to the core at the expense of periphery, which was a “flight to safety” trade. The chart below highlights exactly this. It was only then that the risk parity strategy started to outperform.
Thus, for a robust risk parity strategy one would require differentiation of assets by volatility and correlation. Otherwise, it provides no obvious benefits over market capitalization strategy.