Basic HTML Version
Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
I
23
Thus far, uptake of this new portfolio approach is limited and
is estimated to be no more than 10%-20% of the institutional
investor universe. Interest is also highly regionally focused,
with US investors most receptive to this approach, European
investors showing some curiosity and Asian Pacific investors
not really showing much movement in this direction.
One signal that we may be at just the start of this trend,
however, has been the sharp increase in interest in all-
weather funds that pursue a form of this risk-aligned portfolio
construction, known as risk parity.
All-Weather Products Create Risk Parity Across
Asset Classes to Deliver Returns
A form of risk-aligned portfolio that has gotten a lot of press
attention recently is an approach called risk parity. When
pursuing risk parity, investors divide their risk budget out
equally across every asset in their portfolio and then determine
how much of each asset type they need to hold in their
portfolio to keep that risk allocation in a steady proportion,
actively moving their allocations around to maintain this
balance. The origins of risk parity go all the way back to the
original emergence of Markowitz’s MPT. As discussed in
Section I, the risk-free assets line (sometimes known at the
capital market line) intersects the efficient frontier at the
point of the tangency portfolio. This capital line also serves
to illustrate another principle. In 1958, James Tobin, another
financial markets academic of Markowitz’s vintage, drew the
line to show the inclusion of cash or an equivalent risk-free
asset, such as a 90-day treasury bond, on a potential portfolio.
As shown in Chart 11, all of those portfolios that lie along the
lower portion of the capital market line (between a 100% risk-
free asset portfolio and the tangency portfolio) represent some
combination of risky assets and the risk-free asset. When the
line reaches the tangency portfolio intersection, this is the
point at which the portfolio has all risky assets (ie, equities
and bonds) and no cash or risk-free assets. The extension of
the capital market line above the tangency portfolio shows the
impact of borrowing risk-free assets and applying leverage to
a portfolio by using those assets to purchase more of one of
the risky assets.
In the risk-parity approach, investors take a balanced portfolio
that typically works out to be close to the tangency portfolio,
but then apply leverage to the lower risk portions of that
portfolio using borrowed risk-free assets to lever the tangency
portfolio and move up the capital market line. As shown,
these portfolios can provide superior risk-adjusted returns
versus the traditional 60/40 portfolio because they have a
higher Sharpe ratio—meaning they deliver better returns for
each unit of risk.
the idea of using leverage in portfolios has been around for a
long time, but institutional investors had an inherent aversion
to this proposition and the mechanics of obtaining and
managing the borrowing of risk-free assets were difficult in
the 1950s through 2008. The introduction of treasury futures,
however, began to change that paradigm.
In 1996, Bridgewater Associates introduced a product
called the all-weather fund that was based on risk-parity
principles. The lore around the all-weather fund suggests
that Bridgewater’s founder, Ray Dalio, created the fund to
“ Pre-2008, one out of every 100 pensions had the risk parity
approach. Now you see a lot of people considering it, moving
toward it or adapting it outright. Now we’re up to about
10 out of 100 having adopted risk parity, but everyone is
thinking about it,”
– <$1 Billion AUM Hedge Fund
“ Risk parity is critical to our investment philosophy and to our
investors’ portfolio,”
– Outsourced CIO
“ We’ve taken about 6% of the portfolio and dedicated it to
opportunistic, because sometimes things don’t fit in one
of the buckets and we don’t want to bucket something just
for the sake of bucketing. This opportunistic bucket for us
is based on a risk-parity approach. Instead of putting this
money in cash, we’ve put it in risk parity for the interim
2-3 year investments,”
– US Corporate Pension
Chart 11: Illustration of Underlying Approach
toward Risk Parity Portfolios
Risk% (Standard Deviation)
Return %
Chart 19
Tangency Portfolio -
All Risk Assets &
No Risk Free Assets
60/40 Portfolio
Combinations of Risk
Free and Risk Assets
Leveraged
Tangency Portfolio
Leveraged Portfolios
Data shown in this chart are for illustrative purposes only.
Source: Citi Prime Finance abstracted from work by Tobin, Markowitz, Sharpe & Lintner