Salient Partners’ new Risk-Parity Index replicates the performance of an equally risk-weighted allocation to four asset classes: global equity, interest rate, credit, and commodity futures contracts and swaps, explains Lee Partridge.
Kate Stalter: Today, I’m speaking with Lee Partridge. He’s the chief investment officer at Salient Partners.
Lee, I understand that you have a new index that Salient has started. Tell us a little bit about this.
Lee Partridge: Yeah, that’s correct, Kate. Our index is the Risk-Parity Index sponsored by Salient. The main objective of the index is to track the risk-parity strategy, as normally implemented by most traditional investment managers.
The concept of risk-parity is that rather than having risk in a portfolio concentrated in any one asset class, whether it’s equities, or bonds, or credit-sensitive investments, to have risk divided equally across a number of different asset classes or return streams.
In our particular case, we target equity markets, credit markets, interest-rate markets—as represented by high-quality government debt—and commodity markets, and split the risk of the portfolio evenly across those four slices of the pie.
We also target an exact level of risk, as opposed to an exact dollar allocation. So by targeting an exact level of risk, we’re much more able to avoid experiences of deep drawdowns, or fat tails, if you will.
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Kate Stalter: How do you identify these levels of risk? That’s pretty interesting.
Lee Partridge: Yeah, the main concept is: If you look at a traditional portfolio framework of 60% equities, 40% bonds, which a lot of investors are familiar with, the level of volatility associated with that portfolio is about 10% per year.
So, the annualized standard deviation of returns is about 10% per year. We use that as a starting point to basically target that level of risk.
It also happens to be right at the center of where most risk-parity portfolios have been. We’ve seen a range of 8% up to about 12% at the high end of volatility ranges for risk-parity strategies.
Kate Stalter: Let’s drill down a little bit then, and tell our listeners about some of the investments you’ve been able to identify using this strategy.
Lee Partridge: Sure. There’s actually 46 futures contracts that are embedded in the index, and those are spread across commodities, again government bond markets and equity markets, and then we have an additional five credit indices that we track within the index as well. And that’s spread between the US, Europe, and emerging markets.
When we bring all 51 of those contract exposures together, we can construct a portfolio that really has that balance of risk across those four major asset classes, that just as importantly balance of risk within the asset class.
So if you look at commodities, for example, most commodity indices or even ETFs have a real concentration of risk within the energy space. This particular strategy equally divides risk across energy, mining, and agricultural exposures. So that’s with respect to the index itself, and measuring the performance of the strategy.
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What is also relevant for investors is that we’ve identified a way to implement this just using 11 ETFs that are readily available in the market, and even a retail investor—once they understand how to calculate the risk contribution of each portion of the portfolio—can actually implement this for themselves, using ETFs as the tools that build the portfolio.
Kate Stalter: How often will you be trading in and out of some of these ETFs once you do identify the appropriate risk level?
Lee Partridge: I’ll go back to the index. The index rebalances on a monthly basis, so on the ETF strategy, it makes sense if one is trying to replicate an index type of exposure with ETFs, to also rebalance on a monthly basis.
Kate Stalter: Can you say anything about some of the ETFs that you are holding right now as part of the strategy?
Lee Partridge: Sure, I mean, it ranges from, and again this it not really our—I’m not advocating this is our strategy; this is just a framework that investors could use to think about how to create this for themselves.
But Greenhaven Continuous Commodity Index Fund (GCC) is a commodity ETF that’s available in the market. It has a broad allocation across metals, agriculture, and energy.
Also, we have identified some very liquid ETFs to track different capital structure points within the US, so if you look at Spyder Trust (SPY), certainly a good representation of the large-cap universe. iShares Russell 2000 Index Fund (IWM) does a great job of representing the small-cap universe. MSCI EAFE Index Fund (EFA) would be a good representation of non-US developed markets, and MSCI Emerging Markets Index Fund (EEM) is a very good representation on the emerging-market side.
Kate Stalter: And once again, people should not necessarily be viewing these as buy and hold for the ages? They should go back and re-examine when to rebalance?
Lee Partridge: And the goal is to rebalance to a constant risk level, as opposed to a dollar level.
So, there’s one of two ways that you can approach your allocation targets. You can either target a dollar allocation, and by doing so you allow the risk allocation to move around…so the split between, say, stocks and bonds from a risk standpoint is constantly changing, and the level of risk in that portfolio is constantly changing.
Or, you can lock the level of risk and determine how that’s going to be distributed within the pie, and then allow the dollar allocations to adjust to maintain that constant level of risk and a constant distribution of that risk throughout the portfolio. So, you have to be rebalancing consistently.
Kate Stalter: Something you just said made me wonder: What would determine a person’s level of risk? It is age, income, market conditions, all of the above? How would that be determined?
Lee Partridge: That’s a great question, and most people don’t put a lot of thought into what their actual risk tolerance is. And we think that that’s somewhat of an art.
This whole strategy is determining exactly how much you can afford to lose under extreme circumstances, and then making sure that you’re getting the maximum level of return for the level of risk you’re assuming.
Now, most investors are fairly comfortable with about a 10% level of risk. That really means that about 5% of the time you might lose a little over 20% in your portfolio, which a lot of investors feel is within their risk tolerance.
If you look at a 60/40 portfolio by comparison—which also has about a 10% annualized volatility, a 60% stock, 40% bond portfolio—the problem with that portfolio is that it’s so concentrated in equity markets that during bad years like 2008, we find that it doesn’t exhibit normal distribution. It, in fact, has a very fat tail, and in 2008, that portfolio would have lost 37%, where a risk-parity portfolio would have lost less than half that amount at the same targeted level of volatility.
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