A Dead Simple 2-Asset Portfolio that Crushes the S&P500 (Part 2)

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A Dead Simple 2-Asset Portfolio that Crushes the S&P500 (Part 2)

In Part 1, and Part 1.5 I introduced a simple 2-asset portfolio that substantially outperformed the SPY ETF since 2009. In Part 1 I examined the performance of an "inverse risk-parity" approach where the ETF with the largest volatility contribution to the portfolio was weighted more heavily. In Part 1.5 I examined the performance of the actual "risk-parity" approach, where the ETF with the smallest volatility contribution is weighted more heavily. In this post I will examine some of the conceptual foundations underlying the strategy.

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A Dead Simple 2-Asset Portfolio that Crushes the S&P500 (Part 1.5)

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A Dead Simple 2-Asset Portfolio that Crushes the S&P500 (Part 1.5)

In Part 1 of this series I shared a simple strategy which showed outsized performance relative to the SPY ETF since 2009. I made a small error in the implementation. The previous portfolio was not rebalanced according to a  risk-parity framework. It was actually the inverse. The strategy was rebalanced such that the ETF responsible for the highest percentage of the portfolio's volatility was weighted more heavily! Surprisingly this error did nothing to substantially alter the performance of the portfolio and in some ways was superior to the actual risk-parity approach. In this post I detail the performance of the actual risk-parity approach.

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A Dead Simple 2-Asset Portfolio that Crushes the S&P500 (Part 1)

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A Dead Simple 2-Asset Portfolio that Crushes the S&P500 (Part 1)

I'm going to share a portfolio with you that has absolutely annihilated the performance of the market (as proxied by SPY) since the recovery began in 2009*. The strategy has not had a down year since. This portfolio maintains constant exposure, has 1 un-optimized parameter and wins on a risk-adjusted basis even after considering reasonable transaction costs.

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Was David Woo Right; Was the Selloff Exacerbated by Risk Parity Strategies?

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Today after the close Bloomberg TV had David Woo, Managing Director and Head of Global Rates and Currencies Research at Bank of America/Merrill Lynch, on to provide some insight regarding recent market action. More specifically, he addressed how Chinese and American markets are linked.

He dropped a lot of gems during his segment but one point really struck a chord with me. He said that the recent selloff has likely been exacerbated by "Risk Parity Guys". 

If you're unfamiliar with 'risk parity' here are some good working definitions:

“Risk parity (or risk premia parity) is an approach to investment portfolio management which focuses on allocation of risk, usually defined as volatility, rather than allocation of capital.”
— https://en.wikipedia.org/wiki/Risk_parity
“A portfolio allocation strategy based on targeting risk levels across the various components of an investment portfolio. The risk parity approach to asset allocation allows investors to target specific levels of risk and to divide that risk equally across the entire investment portfolio in order to achieve optimal portfolio diversification for each individual investor. ”
— http://www.investopedia.com/terms/r/risk-parity.asp

Essentially, this says that risk parity strategies approach portfolio allocation based on the underlying asset's risk/volatility as opposed to traditional portfolio allocation which allocates capital based on holding some specified amount of each asset class. 

David Woo went on to elaborate that traditional asset class correlations began to break down during this selloff, implying that traditional methods of diversification were no longer viable and as a result any fund/fund manager which allocates capital on the basis of 'risk parity' or similar strategies would be forced to reduce risk across all asset classes. 

I thought this was a brilliant insight and immediately wanted to see if I could find some evidence that would support his analysis. 

To do this I used my Composite ETF model to plot rolling correlations of the 'Bonds' ETF composite vs the ETF composite of each asset class. The reason I use rolling correlation is because of the inherent link between asset correlations and volatility. Specifically, as correlations across assets/asset classes rise diversification decreases and volatility/tail risk increases.  I've selected some of the more interesting plots that lend credence to his statement.

bonds vs asia-pac equity

Data Source: Yahoo Finance

bonds vs consumer discretionary

Data Source: Yahoo Finance

bonds vs consumer staples

Data Source: Yahoo Finance

bonds vs europe equity

Data Source: Yahoo Finance

bonds vs financials

Data Source: Yahoo Finance

bonds vs global equity

Data Source: Yahoo Finance

bonds vs industrials

Data Source: Yahoo Finance

bonds vs large cap

Data Source: Yahoo Finance

bonds vs materials

Data Source: Yahoo Finance

bonds vs mid cap

Data Source: Yahoo Finance

bonds vs precious metals

Data Source: Yahoo Finance

bonds vs real estate

Data Source: Yahoo Finance

bonds vs small cap

Data Source: Yahoo Finance

bonds vs telecom

Data Source: Yahoo Finance

After reviewing some of the evidence I would say David Woo is on to something.  To be fair however, rising correlations among this many asset classes over a short time period is likely to cause multiple types of fund strategies to reduce risk exposures quickly. 

If you haven't seen his segment I'd recommend trying to find it. Either way I'll be on the lookout for his analysis going forward.