Perseverance
A dynamic Risk Parity portfolio
This paper explains the concept of Perseverance portfolio, describes a Simple Risk Parity Strategy behind it which has consistently outperformed over 40 years, and delves into more advanced portfolio construction and risk management techniques used in Perseverance.
01
Introduction
The success of Risk Parity strategies during past crises provides evidence for the benefits of a diversified portfolio that focuses on risk allocation rather than just dollar allocation. Traditional portfolios are often dominated by equity risk, which can lead to concentration risk and less consistent performance. By investing in non-equity asset classes, investors can achieve true diversification and expect more stable returns across different economic environments.
Most portfolios today have more than 60% of their assets allocated to equities, which are three to four times riskier than bonds. Therefore, these portfolios have roughly 90% of their risk budget concentrated in equities, making traditional asset allocations highly concentrated in equities and not diversified at all from a risk perspective. Traditional portfolios create the illusion of diversification, when in reality they have concentrated exposure to the equity markets. As a result, this concentration risk leads to lower risk-adjusted returns, less consistent performance across economic environments, and higher tail risk.
Traditional 60/40 Portfolio
02
The concept behind risk parity
Asset classes offer a risk premium that is predominantly the same once adjusting for risk, however their sensitivities to changes in the economic environment are not the same. The Risk Parity strategy leverages these relationships by maintaining comparable risk exposure to assets that perform well under different economic conditions, such as when growth or inflation speeding up or slowing down. This is done through four sub-portfolios, each aimed at capturing one of these four risk exposures.
As a result of this parity, if a specific asset class underperforms in a particular economic environment, such as equities during lower-than-expected growth, another asset class with an opposing sensitivity, such as nominal bonds, will automatically offset it, allowing the risk premium to be the primary source of returns and delivering a more consistent overall portfolio return.
Four Economic Risk Exposures
Disinflationary Bust
Disinflationary Boom
25% of Risk
Inflation Speeding Up
Inflation Slowing Down
Growth Speeding Up
Growth
Slowing Down
Stagflation
25% of Risk
Inflationary Boom
25% of Risk
25% of Risk
Asset Sensitivities to Economic Environments
03
Environmental Biases of Equities, Treasury Bonds, and Commodities
To demonstrate the dependability of the environmental framework, Perseverance utilizes historical performance data of factorized portfolios consisting of: one that rises/falls following changes in growth expectations and one that rises/falls following changes in inflation expectations, with the risk variable equalized to isolate the effects of shifts in the economic environment. In general, it can be observed that assets tied to rising growth/inflation responded similarly in magnitude but opposite in direction to assets tied to falling growth/inflation. Therefore, balancing these two types of assets would have reliably mitigated the impact of environmental shifts. This approach is designed to provide consistent balance as it is based on an understanding of the inherent nature of asset pricing structure.
Inflation
Growth
Rising
Falling
Commodities
Equities
Treasury Bonds
Equities
Commodities
Treasury Bonds
04
Risk Parity Performance
Performance Metrics
End Balance
Annualized Return
Sharpe Ratio
Standard Deviation
Max Drawdown
Perseverance
$182,553
S&P 500
$182,553
10.09%
10.09%
0.74
0.41
7.37%
15.38%
-10.84%
-50.80%
Historical Market Stress Period
Black Monday
Sep '87 - Nov '87
Asian Crisis
Jul '97 - Jan '98
Russian Default
Jul '98 - Oct '98
Dotcom Crash
Mar '00 - Mar '09
Great Recession
Nov '07 - Mar '09
Covid-19
Jan '20 - Mar '20
Perseverance
-8.30%
-3.25%
S&P 500
-29.78%
-5.61%
-1.68%
-15.38%
-6.00%
-44.82%
-8.14%
-50.97%
0.00%
-19.63%
05
Engineering Risk adjusted Return
A portfolio constructed using the Risk Parity strategy provides a greater return-to-risk ratio compared to a concentrated portfolio. The return-to-risk ratio of Perseverance, which follows the Risk Parity approach, is expected to be approximately twice that of a conventional portfolio dominated by equity. This higher ratio can be utilized to attain the same level of return with less risk or to obtain greater returns for the same amount of risk, or a combination of both.
The higher return-to-risk ratio in a portfolio constructed using the Risk Parity strategy can be utilized in different ways. This is because the return of a portfolio is the average of the returns of its individual assets, and the return and risk of each asset can be adjusted to any reasonable level through many forms of leverage. For instance, the Perseverance portfolio can have a similar expected risk to a portfolio fully invested in the S&P 500 but with a significantly higher return.
