The goal of diversification is inarguably appealing: build a balanced portfolio that maximizes return for a given risk level. However, when it comes to risk parity investing, diversification is pursued quite differently than strategies driven by Modern Portfolio Theory. With risk parity, keeping it simple can lead to a more balanced and efficient portfolio.

Let’s look at our investment positioning at SineCera Capital. Currently, our All-Weather Core portfolio has 100% of its equity exposure in the broad U.S stock market. That allocation corresponds to an approximate 34% portfolio risk contribution (based on a rolling 10-year period analysis). Not surprisingly, we are asked why we don’t diversify into international equities or make targeted investments in sectors that may have higher expected returns.

The answer…broad-based U.S equity exposure is the most efficient way to capture the equity risk premium (for now).

In general, assets that have higher expected returns also have higher standard deviations (i.e. higher risk), and contribute more to a portfolio’s total risk. Therefore, a lower amount would be invested in riskier assets to maintain the same marginal contribution to portfolio risk.

For example, if our equity weighting had been entirely invested in a small-cap stock index, our equity risk contribution would rise from 34% to roughly 47%; splitting the allocation 50/50 would have increased equity risk contribution to 40%.[i]

Instead of reducing our dollar-weighted exposure to accommodate more volatile equities, our current equity positioning (consisting of market-weighted exposure to large-, mid- and small-capitalization U.S. stocks) allows us to maintain a more balanced approach across stocks, bonds, and inflation-hedging assets.

However, risk contribution is not just a function of volatility; correlations have a significant impact as well. Assets with high standard deviations that are negatively correlated to stocks can actually help increase overall equity exposure. For example, investing in long-term U.S Treasuries allows us to increase equity exposure because these two assets are negatively correlated and long-term Treasuries have a higher risk profile than shorter duration bonds of similar credit quality. When it comes to fixed income, investing in “safer,” less-volatile bonds would limit our ability to allocate more into equities, and lessen our portfolio’s ability to generate positive returns during stock market rallies.

[For more information on our bond positioning, you can read that blog post here].

Most institutional risk parity investors solve for this by leveraging their portfolio. But, as we have seen with the latest market correction, leverage not only may enhance upside potential, but it also may hamper the downside protection offered by the underlying assets in a risk parity portfolio. In a levered portfolio, heightened market volatility also requires more frequent rebalancing—costs that we happily avoid by not employing leverage.

What About International Equities?

Unless correlations shift meaningfully away from the broad-based U.S market, investing in international stocks does not currently make sense for us. Unfortunately, the case for international diversification has grown weaker over the past two decades.

Starting in the late 1990s, international and domestic equity correlations have risen sharply, and have steadily remained above a 0.8 correlation for the past two decades. Increasing globalization, spurned on by the internet boom of the late 90s, have been noted drivers of this rising correlation.[ii] As stated in a late-2019 Morningstar report[iii],

“It seems unlikely that we’d see correlations return to the same low levels as in the past.”

A 0.8 correlation, or even a 0.9 correlation, does still offer marginal diversification benefits. However, when combined with the fact that international equities have been consistently more volatile than U.S counterparts,[iv] our All-Weather Core will only allocate to international stocks on a tactical basis. Knowing that international equities may again outperform U.S. equities, we will continue to monitor the correlations for a meaningful change in risk-adjusted returns. This risk/reward tradeoff favors our current strategic positioning.

How Global is the U.S. Stock Market?

It's also important to note that a market-weighted allocation to U.S. equities still captures a substantial amount of global economic exposure. Between 2008 and 2018, foreign revenue (i.e. sales from products and services produced and sold outside the U.S) consistently accounted for over 40% of the total revenue generated by S&P 500 companies. In 2018, it accounted for 42.9%.[v]

Within our All-Weather strategy, we may extend our equity exposure from its target risk contribution of 33% up to 43%. This gives us the ability to diversify outside the U.S. as opportunities arise, without necessarily reducing our current dollar-weighted equity exposure. But, between COVID-19, negative GDP growth across multiple markets, Brexit, and OPEC nation handwringing, there are a lot of negative externalities affecting the global economy. Given this market environment, we feel more confident fully allocating our equity exposure to U.S stocks and maintaining a neutral risk weighting near the 33% risk parity target.

As always, if you have any questions, please do not hesitate to contact us.

Best Regards,

Adam J. Packer, CFA®

Chief Analyst | SineCera Capital