Here’s a little-known fact: The traditional 60/40 portfolio, when using the aggregate-bond index for its fixed-income allocation, has a 99% correlation to the returns of the S&P 500.  Rob Arnott pointed this out in 2004, and it remains true today. 

One way to overcome the limited diversification value offered by the aggregate index is to use a risk-parity approach.  In this article, I explore the concept of risk parity in asset allocation and how it provides value for portfolio management. 

Risk parity is a very simple idea.  Investors want to combine assets with low correlations in a portfolio, so that fluctuations in one asset class will offset those in another.  The simplest example is stocks and bonds, which are historically uncorrelated.  Combining them will reduce a portfolio’s exposure to either of these asset classes individually. 

The correlation of the portfolio returns to an individual asset class characterizes the degree to which the volatility of the portfolio is driven by that asset class. 

Risk parity is gaining popularity.  The State of Wisconsin’s Investment Board recently invested $600 million of its pension assets in risk-parity strategies.

The ideal situation for investors is to combine asset classes with the same level of volatility, but fairly low correlation to one another.  Many of the asset classes that have low correlation to stocks, however, have very different volatility from stocks. 

For example, the S&P500 has historical volatility that is almost four times the volatility of the aggregate bond index, which is why the ability of the bonds to mute swings in the S&P500 is so low despite their low correlations to the stock market.  We can increase the impact of the aggregate bond allocation by increasing the allocation to bonds, but this in turn lowers the portfolio’s expected return. A portfolio with balanced volatility from stocks and bonds, for example, would consist of 20% in the S&P500 and 80% in the bond index, but this portfolio has lower risk than many investors desire.

One solution is to use leverage to increase the effective volatility of the bond position.  By levering the lower-volatility asset classes, we would create a portfolio with lower correlation to the S&P500 and solve the volatility mismatch. But risk parity can also be achieved far more simply without leverage, by moving from the aggregate bond index to bond indices with higher credit or duration risk.  For example, we might simply increase the duration of the bonds in the portfolio to match the volatility of equities.  As we increase the risk of the bond allocation (either directly or via leverage) to more closely match the volatility of stocks, however, note that we are also increasing the portfolio’s sensitivity to interest rates. 

The table below shows a series of asset classes, represented by ETFs, along with their historical volatilities and correlations to both the S&P500 and the aggregate bond index.

Trailing 3 year Volatilities

From the table above, we can see that the intermediate-government bond index (IEF) and the long-government bond index (TLT) have markedly higher volatility than the aggregate bond index (AGG), thereby making it easier to match the risk in the bond portion to the risk in the stock portion of the portfolio.  Indeed, intermediate- and long-government bonds provide the perfect way to illustrate risk parity.  Both IEF and TLT have essentially identical correlations to the S&P500.  TLT is, however, about twice as volatile as IEF, and its volatility is close to that of the S&P500.