Risk Parity. Alex Shahidi

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Risk Parity - Alex Shahidi


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the conventional thought process for developing a portfolio that involves scaling up and down risk by allocating more or less to equities versus less risky bonds. In short, I am asking you to temporarily suspend any preconceived notions about building a properly diversified portfolio so we can start from a blank slate.

      The Economic Environment Drives Asset‐Class Returns

      Imagine that you own a small private business that develops and sells a product. Would you generally expect sales to improve or decline during an economic collapse like 2008 or the first quarter of 2020? Unless you sell something extremely unique, most would answer that a material economic downturn is probably an unfavorable environment for your business. Likewise, if we are in the middle of a prosperous period and business is booming, you should reasonably expect the value of your venture to increase. What if your expenses unexpectedly spike due to rising inflation and you are unable to fully pass through the increase to your customers? Wouldn't it make sense that the value of your profits would be negatively impacted, and the opposite would be true if your input costs declined?

      The stock market works the exact same way and is supported by an identical rationale. A stock represents an ownership stake in a public company. The stock market is simply made up of a large basket of individual stocks and provides a broad representation of public company performance. The main difference between a public stock and your private business is that the former trades on a stock exchange and its value is correspondingly fully transparent on a daily basis. Anyone can transact in a share of the stock, and the market of potential buyers and sellers sets the prevailing price, which is largely based on the knowledge of the public. The consensus ultimately establishes the fair market value of the business according to its perceived value, which, just like your business, is heavily influenced by the economic environment. This is why the stock market plunged 33% in five weeks during the onset of COVID‐19. Investors were justifiably terrified that revenues would fall off a cliff as the economy was shut down. Even though you may not have perceived the value of your private business to have similarly declined because its price is not published every second, you would have likely suffered a similar fate at that time.

      Of course, a single business's cash flows are more likely to exhibit idiosyncratic factors specific to its revenues and expenses. If your private business provides software solutions and the cause of the economic downturn is a global pandemic, then your revenues could soar, whereas a travel agency may not be as fortunate. However, when we take the entire stock market in aggregate, the unique aspects to each business net out, and the overall economic environment becomes the primary driver of returns.

      Importantly, when we refer to rising and falling growth and inflation, we should think of it relative to what was originally discounted. In other words, if the market expects and is priced for 3% growth and we get 1% growth, then that is a negative influence on assets biased to do well when growth is improving, even though the economy grew. Buyers and sellers agreed on a price level that factored in 3% growth and only received 1%. Therefore, the price discounted more growth than actually transpired. Once the knowledge of the lower growth rate gets recognized, then the value of the market declines, all else being equal, to reflect this lower growth. Since current and future expected cash flows are now lower than previously thought, this means, practically, that businesses are now worth less than they used to be, since they are expected to produce lower profits. Prices adjust to reflect this shift. Changes in inflation work the same way.

      Similarly, if growth is very strong, demand for capital will increase from borrowers eager to build or expand their businesses. Greater demand to borrow also pushes up interest rates, just as rates decline when growth weakens and demand for capital falls.

      Treasury Inflation‐Protected Securities (TIPS) are similar to Treasuries in that they are government‐guaranteed bonds and can serve as a safe‐haven asset. They differ from Treasuries in that they are directly linked to inflation, because these securities pay the holder the prevailing inflation rate as measured by the consumer price index (CPI). Therefore, TIPS are biased to outperform in the exact opposite environment of equities – namely, falling growth and rising inflation. They are also a good diversifier versus Treasuries even though TIPS and Treasuries are both government bonds. The latter outperforms during falling inflationary periods and does poorly when inflation rises since it receives a fixed interest rate as opposed to an inflation pass through.

      Commodities are another diversifying asset class. We can break commodities down into two subgroups: industrial commodities and gold. Industrial commodities include energy, industrial metals, and agriculture, which are considered good inflation hedges. This is because higher commodity prices are actually one component of general price inflation since they are a key input into many goods and services, and are literally part of the CPI measure. Gold, on the other hand, is more of a currency and a storehold of wealth. Its price is far less influenced by aggregate demand as an input to produce something else. Consequently, the economic bias of industrial commodities is to outperform in rising growth and rising inflation environments whereas gold is more of a falling growth, rising inflation asset. It also serves as a useful diversifier against more extreme growth and inflation environments and periods of crisis. The year 2008 and the first quarter 2020 offer good examples of the divergence: gold rallied in both


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