By Anthony Warr
Since the global financial crisis, many investors have been drawn to promises of high return and low risk. After all, that sounds like a magic combination. But as with all magic tricks, it pays to be sceptical.
It’s quite natural that after a period of extraordinary volatility in markets people would be attracted to new, often elegant-looking models that offer a better return for a given level of risk or similar returns to that of a market portfolio with less risk.
These strategies, which go by such names as “minimum variance” or “risk parity”, are attempts to manage the risk of a portfolio to offer greater downside protection for investors at no additional cost.
This is obviously a potent marketing strategy and an easy sell in a climate where many investors have moved from the pre-2008 world of an overwhelming focus on maximising return to one almost wholly focused on minimising risk.
But building and selling a superficially attractive strategy to meet current consumer appetites is one thing. Ensuring it meets the highest theoretical, empirical and practical standards across multiple time periods is another.
A suggested approach in evaluating any new strategy, and one favoured by the WARR HUNT investment committee, is to submit it to a three-step challenge:
- Firstly, is it sensible and based on financial economics? This means does it have a theoretical justification.
- If it passes that test, is it persistent and pervasive? In other words, is it overly influenced by the recent past or does it extrapolate past returns to the future?
- And if it clears those hurdles, can it be successfully implemented so as to improve expected returns? Making an idea work on paper is one thing. Making it work in a practical sense and at a reasonable cost is another.
Research shows strategies like “minimum variance” work by taking big bets on particular industries such as utilities or by tilting to certain types of stocks.
It is an elegant model and has theoretical foundation. So it passes the first test. But it breaks down after that. It assumes variance is the only measure of risk. It’s really just a tilt to value and it leaves the market premium on the table. Finally, it is heavily concentrated in a couple of sectors.
In contrast, risk parity strategies spread volatility risk equally across asset classes. Promoters of this approach say it gives you better diversification and investment results than what you would achieve, under a traditional balanced portfolio.
The approach involves increasing a portfolio’s allocation to low variance assets to the point where they contribute the same variance as other assets. The result is a portfolio dominated by bonds. Once contributions are equal, leverage can be applied to control the overall level of volatility. Simulations based on the past 30 years of returns show the risk parity portfolios provide greater returns per unit of volatility.
Applying our three-stage test in this case brings down this approach at the first hurdle, because there’s no theoretical justification for lower risk leading to higher expected return. Moving to the second hurdle, we find these are really just leveraged bond strategies that are highly sensitive to changes in interest rates and are heavily influenced by the fact that bond yields have fallen dramatically in recent decades.
So what are the alternatives?
Sometimes a simple approach is best. In all these cases, traditional balanced strategies achieve similar or better results than the new low volatility approaches.
Investing involves trade-offs. We may want high returns, but can we live with high volatility? If we reduce volatility, are we just loading up on another risk like too much leverage or taking big bets on a few sectors?
Ultimately, we need to focus on the trade-offs that matter. That means identifying the dimensions of expected returns, building portfolios along these dimensions to deliver results and focusing on the real-world frictions of doing so.
Most of all, it requires us to maintain a healthy scepticism about superficially magic solutions that promise us the best of all possible worlds.
Magic is fine by the way. But when it comes to your long-term investments, employing solid theory, sound evidence and seasoned practice offer a better approach.