Benchmarking Risk Parity Strategies

Since the launch of the first risk parity fund—Bridgewater’s All Weather fund—in 1996, many investment firms have begun offering risk parity funds to their clients. Risk parity funds became especially popular in the aftermath of the 2008 global financial crisis, when many investors witnessed the failure by traditional U.S. dollar-based asset allocation to provide downside protection.

Despite the popularity of risk parity funds, up to this point, the strategies have lacked an appropriate benchmark to measure their effectiveness and performance. Most market participants typically use a traditional 60/40 equity/bond portfolio[1] or a broad equity market index, such as the S&P 500®, to benchmark the performance.

The recent launch of the S&P Risk Parity Indices provides a suite of appropriate rules-based and transparent benchmarks for risk parity strategies. The indices also reflect the risk/return characteristics of strategies offered in this space.

Each S&P Risk Parity Index seeks to track the performance of a hypothetical portfolio that consists of 26 futures contracts from three asset classes (equity, fixed income, and commodities). Each index targets a constant level of volatility from each asset class, as well as each constituent futures contract. The series has three subindices, reflecting volatility targets of 10%, 12%, and 15%.

In this four-part blog series, we will use the S&P Risk Parity Index – 10% Target Volatility (TV) as an example to illustrate this index series’ performance, risk attribution, capital allocation, and methodology. In Part I, we will focus on the historical performance of the index.

Exhibits 1 and 2 show the cumulative returns of the index and key performance statistics. We compared it to a traditional 60/40 equity/bond portfolio. We want to point out that the latter does not completely reflect the risk/return characteristics of a risk parity strategy but is used ubiquitously in fund literature to benchmark. We also included the HFR Risk Parity Vol 10 Index as a proxy of active risk parity funds in the market. For reference, the HFR Risk Parity Indices represent the weighted average performance of the universe of active fund managers employing an equal risk contribution approach in their portfolio construction. These indices also have three volatility targets (10%, 12%, and 15%).

Historical performance shows that the S&P Risk Parity Index – 10% TV tracked the composite performance of risk parity active fund managers closer than a traditional 60/40 equity/bond portfolio did. The former had a higher correlation (0.89 versus 0.76) and lower tracking error (3.99% versus 6.54%). The overall annualized returns, realized volatility, and Sharpe ratio of the S&P Risk Parity Index – 10% TV were also close to the composite performance of active risk parity fund managers.

The S&P Risk Parity Index – 12% TV tracked the composite of risk parity active fund managers with a correlation of 0.85 and a tracking error 5.26%, and the S&P Risk Parity Index – 15% TV had a correlation of 0.87 and a tracking error of 6.09%.

The risk/return performance figures showed that the S&P Risk Parity Indices can be used as a benchmark in performance evaluation of active risk parity funds.

[1] The 60/40 equity/bond portfolio is hypothetically constructed by combining the S&P Developed BMI with 60% weight and the S&P Global Developed Aggregate Ex-Collateralized Bond Index with 40% weight, rebalanced monthly.

The posts on this blog are opinions, not advice. Please read our disclaimers.

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