LIDO INSIGHTS | Risk Parity Strategy | February 2021
Asset allocation designed for all seasons.
When thinking about asset allocation, the central problem is that it is impossible to predict economic conditions and time the resulting market direction on a repeatable basis. Most asset allocation portfolios are not stress tested or diversified across multiple economic outcomes.
We must first reframe our thinking around the economic conditions of growth and inflation, both rising and falling.
The approach requires both diversification and risk balancing. However, we must first reframe our thinking about asset classes around the economic conditions of growth and inflation, both rising and falling. The reason for this is that future price movements will be driven by changes in market expectations around these unpredictable conditions. With this in mind, we select four diversified asset classes that have previously outperformed in different economic environments. Next, we balance these asset classes using a simple, yet robust quantitative model as a guide. The result is a diversified, institutional grade asset allocation portfolio that is equally suited to individual investors.
The objective of the Lido Risk Parity strategy is to achieve returns less correlated with equity, with lower volatility and lower risk of capital loss. More specifically, to survive and thrive in varying conditions a portfolio should: generate positive returns when the economy is good, minimize risk of loss of capital to the extent possible, and preserve real returns when there is inflation.
Risk Parity Objectives:
- Generate positive returns when the economy is good
- Minimize risk of loss of capital to the extent possible
- Preserve real returns when there is inflation
Implementation is key.
Quantitative risk measurement
While risk parity is a sound concept, implementation is the key to successfully achieving the objectives above.
Asset classes must be chosen carefully based on both correlation to stocks and annualized volatility. Risk balancing requires thinking about how these relationships work in combination. Lido Risk Parity uses quantitative methods to assess both correlation and annualized volatility such that risk between asset classes is balanced or roughly equal, hence “parity”.
Lido Risk Parity invests utilizing ETFs across four asset classes: equities, nominal bonds, inflation linked bonds and commodities. These assets perform well across multiple economic environments. The relationship between the assets and the economic environments is not theoretical. It has been measured and observed historically.
The result is a portfolio that seeks to provide truly balanced asset allocation for the long term. It has no hidden bias to a particular economic environment. Thus, as surprises appear and the market reprices, the portfolio holds assets that we believe can do well across the range of possible outcomes. It is designed to be a cost efficient and liquid hedged equity strategy.
While risk parity can be viewed as both timeless and state of the art, it might resonate strongly with readers in 2021. Currently, the range of possible economic outcomes is wide. Central banks globally are desperate to create inflation in response to the deflationary shock of Covid-19. This strong monetary response is complemented by a strong fiscal response. However, it is uncertain whether we will see inflation or if the long-term disinflation trend will continue. This uncertainty is increased due to political disunity. Risk parity has been stress tested across these outcomes. Its inclusion in portfolios is therefore worth considering.
Different asset classes perform well in different economic environments.