Why is Risk Parity one of Wall Street’s favorite positions?
Answer: Because it’s been going up!
And … When you buy stocks and bonds together you get an automatic stabilizer working for you. In the very short run bonds and stocks go in opposite directions so if your S&P position rallies bonds will go down. This allows you to sleep well at night.
It is also true that during times of great stress bonds can rally enough to offset all your horrible stock market losses.
If, over time, inflation remains benign you can win on your stocks and even make something on bonds too. It’s no wonder that famous hedge funds like Bridgewater associates are so closely associated wit this position. They call it their “All Weather Strategy“)
Since we have an index for stock market fuel and an index for bond market fuel, we automatically have one for the combination. A Risk parity position owns the as many bonds as necessary to match the volatility in its S&P position so I can equally eight my bond and stock indices. This is what it looks like:
This chart shows the index for a bout a year and the top plot is a volatility weighted combination of S&P futures plus US 10 year bond futures.
The next chart gives you more history:
To understand the nature of the index we need to look at its historical distribution:
This is obviously not a normal distribution but it makes our lives a little easier. There are plenty of days when you will get an index level of 100 so the index will be unequivocal.
Over the entire tn year period this pair rose .105 pts/day. With that in mind we can look at the performance filtered for various index levels:
To be honest it’s been hard to beat this market’s performance on the upside since it rallied relentlessly in the sample period.
You can nonetheless see the advantage you get by waiting for higher index levels.
This is how returns skew during low index periods:
This is especially important since the series rallied so consistently. When the index was low, returns were significantly inferior to the average +.105 daily gain for the entire period.