The COVID-19 pandemic has triggered a global shutdown and the Dow Jones Industrial Average had its worst selloff since the 2008/2009 financial crisis. Given the current environment, I think it’s important to highlight the importance of a diversified portfolio. Let’s start by comparing the conventional 60/40 portfolio strategy (60/40) with the risk-parity strategy. In short, 60/40 is a traditional asset allocation where approximately 60% of the assets are in equity and 40% are in bonds. About 15 years ago, risk parity began to gain popularity. Risk parity is an asset allocation strategy that balances the portfolio by risk. The more risk a security has, the less weight is allocated to that security, and so naturally the majority of the portfolio is in fixed income. Typically, a risk-parity portfolio would have approximately 70% of the assets in fixed income. Since the expected return of fixed income is lower than that of equity, the return of the risk-parity portfolio, without leverage, is also anticipated to be lower than 60/40 portfolios in some periods. Let’s examine the performance in two different periods:
- 2009 to 2020: During the longest bull market in history, the risk-parity strategy will underperform due to the high allocation in fixed income.
- 2000 to 2020: This length of time includes three recessions (the tech bubble, 2008/2009 financial crisis and COVID-19 pandemic) and allows us to get a full picture of the performance of these two strategies, especially in the current shutdown environment.
Note, the methodology for portfolio allocation and construction can be viewed below.
2009 to 2020
March 2009 to April 2020 was the longest bull market period in history. Risk parity tends to lag behind 60/40 in this environment because of the high allocation to fixed income and the fact that fixed income tends to have lower returns. During this period, our risk-parity portfolio underperformed the 60/40 portfolio by 2.6% per year. However, the risk-parity portfolio had a much higher risk/reward ratio (1.30 vs 0.94). In other words, risk parity was a more diversified portfolio than the 60/40 portfolio.
| March 2009 - April 2020 |
| Strategy | Annualized Return | Standard Deviation | Risk/Reward Ratio | Batting Average |
| 60/40 | 8.7% | 9.3% | 0.94 | 73.8% |
| Risk Parity | 6.1% | 4.7% | 1.30 | 79.5% |
2000 to 2020
Next, I want to compare the overall performance between 60/40 and risk parity for the period of January 2000 to April 2020, which included the tech bubble, the 2008/2009 financial crisis, quantitative easing and the COVID-19 pandemic. In this period, the risk-parity portfolio outperformed the 60/40 portfolio by 0.50% per year with half of the risk. It also had a higher risk/reward ratio (0.93 vs 0.43). Risk parity outperformed 60/40 in all measures during this period because it’s a more diversified portfolio, and more diversified portfolios tend to perform better in down markets.
| January 2000 - April 2020 |
| Strategy | Annualized Return | Standard Deviation | Risk/Reward Ratio | Batting Average |
| 60/40 | 4.3% | 10.1% | 0.43 | 63.5% |
| Risk Parity | 4.8% | 5.2% | 0.93 | 70.1% |
This week’s chart illustrates the maximum drawdown, which is the percentage loss from the previous peak. This helps highlight the benefit of a diversified portfolio. As demonstrated, the risk-parity strategy outperformed during the tech bubble, 2008/2009 financial crisis and the recent global shutdown.
During the tech bubble, risk parity had a drawdown of 6.73%, whereas the 60/40 portfolio experienced a drawdown of 29.08%. Similarly, during the 2008/2009 financial crisis, maximum drawdown was 16.82% for risk parity and 35.48% for 60/40. In recent months, risk parity has had an 8.03% drawdown, whereas 60/40 has had a 15.40% drawdown. Risk parity outperformed in this period because it was able to control the loss. For example, if the portfolio loses 10% of its value, it will need 11% to make it back up. If it loses 35%, it will need 53.8% to break even.
Key Takeaway
Maximum drawdown helps to highlight the benefits of a diversified portfolio. The more diversified the portfolio, the better the portfolio tends to perform in down markets. Risk parity became popular about 15 years ago and after reviewing two full economic cycles, we see how risk parity is still relevant today.
Methodology of portfolio construction and allocation
In this analysis, we used nine indexes, including five equity indexes and four fixed income indexes:
| Index | |
| 1 | MSCI US Net Total Return Local Index |
| 2 | MSCI Japan Net Total Return Local Index |
| 3 | MSCI UK Net Total Return Local Index |
| 4 | MSCI France Net Total Return Local Index |
| 5 | MSCI Germany Net Total Return Local Index |
| 6 | Bloomberg Barclays US Agg Total Return Value Unhedged USD |
| 7 | Bloomberg Barclays Emerging Markets USD Aggregate Total Return Index Value Unhedged |
| 8 | Bloomberg Barclays US MBS Index Total Return Value Unhedged USD |
| 9 | Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged USD |
60/40: 60% of assets in equity and 40% of assets in fixed income. Each security has equal weight within each asset class.
Risk Parity: Assets are allocated by weight using a 36-month rolling standard deviation of monthly returns. The higher the standard deviation, the lower the weight. For example, if asset one has a 9% standard deviation and asset two has a 3% standard deviation, then we will allocate 75% to asset one and 25% to asset two. This naïve methodology assumes correlations of all the securities are equal to one.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.
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