Volatility is a synonym of risk in terms of portfolio management; so that everyone wants to take to their heels when they hear from it. However, you shouldn’t be afraid because there are several methods to control it. Let’s see two of them and the differences between them: risk parity versus inverse volatility strategies.
They can seem to be the same strategy but there is a subtle difference in how they distribute the weights. Let’s see.
The main idea of the risk parity strategy is that all assets in the portfolio contribute in the same proportion to the risk of the portfolio. That is, depending on their own risk, the weight in the portfolio is set.
In the risk parity strategy, risk is measured with the variance. That means that if an asset has low risk (variance), its weight has to be higher to raise the risk contribution of another asset with higher variance.
To illustrate how risk parity strategy works, we use an universe made up with four asset:
- SPDR S&P 500 ETF Trust
- iShares MSCI Emerging Markets ETF
- iShares MSCI Japan ETF
- iShares 7-10 Years Treasury Bond ETF
We use one year prices of these assets, until 30/09/2017. Then we create an equally weighted portfolio and a portfolio following risk parity strategy.
The following image illustrates the asset allocation process that risk parity strategy follows. As we can see, “MSCI Emerging Markets” has the highest variance, as opposite to “7-10 Years Treasury Bond”, which has the lowest variance. So that, the volatility contribution of “MSCI Emerging Markets” to the equally weighted portfolio is higher than one of “7-10 Years Treasury Bond”. Nevertheless, in risk parity strategy the volatility contribution of each asset is the same by weighting them differently.
In inverse volatility strategy the risk is measured with volatility, and assets are weighted in inverse proportion to their risk.
To illustrate the working of this strategy, we use the same ingredients as in the previous strategy: the universe and the period. As we see in the following image, inverse volatility strategy gives more weight to “7-10 Years Treasury Bond”, which has the lowest volatility, and more weight to “MSCI Emerging Markets”, with the highest volatility. However, the volatility contribution of each asset is not the same because this is not the aim of the strategy.
Risk parity versus inverse volatility
The objective of this post is not to compare risk parity versus inverse volatility; even so we will see how different each one works in 2017.
Although the aim of both strategies is to control the portfolio risk, each one does it in different ways. By this the results are similar in terms of returns (as we can see in the following images); however, the exposure is quite different, overall in “7-10 Years Treasury Bond”, which has more weight in risk parity strategy.
I encourage a reader to test his/her own strategies and see how different they work in other scenarios.