Consider an investment strategy that can be pursued today using readily available securities. If those securities were not available in the past, then the strategy has no true antecedent. Backbiting just be done using proxies for the securities, and the choice of proxies can have a material effect on measured returns. In addition, the introduction of new securities can have a material effect on the returns of a strategy; a strategy that seems to have been profitable in the past may become less profitable if the introduction of new securities makes it easier for others to replicate the strategy than was the case in the past.
We consider these issues in the context of a risk parity strategy, which equalizes risk contributions across asset classes, and is typically levered to attach market levels of risk. The cost of financing the high degree of leverage in a levered risk parity strategy can have a material impact on the performance of a strategy. For a liquid asset class such as US Treasury bonds, futures may be the cheapest way to finance the levered position. However, LIST Treasury futures have been traded in a liquid market only since the sass.
So it is impossible to conduct a fully empirical study of risk parity that begins early in the twentieth century because we don’t know how a futures-financed risk parity strategy would have performed during the Great Depression. We can instead estimate what it would have cost to finance the leverage through more conventional borrowing, but small differences in assumptions about the cost of borrowing have major effects on the estimated returns of levered risk parity, precisely because the strategy involves such a high degree of leverage.
Moreover, because the introduction of liquid US Treasury futures markets presumably reduced the cost of financing a levered risk parity, it probably induced changes in asset returns that would tend to offset the savings achieved through lower financing costs. Even assuming that the underlying processes possess some strong form of stationary, the high volatility Of security returns poses two closely related problems: ; The confidence intervals on the returns of a strategy are very wide, even with many decades of data.
Thus, it is rarely possible to demonstrate with conventional statistical significance that one strategy dominates another. ; Even if we were reasonably confident that one strategy achieved higher expected returns than another without incurring extra risk, it would be entirely possible for the eager strategy to outperform over periods of several decades, certainly beyond the investment horizon of most individuals and even perhaps of institutions like pension funds or endowments. In this article, we examine the historical performance of four strategies based on two asset classes: US Equity and us Treasury Bonds. Our study includes a value weighted portfolio, a 60/40 mix, and two risk parity strategies. Unleavened risk parity is a fully invested strategy weighted so that ex post risk contributions coming from the asset classes are equal. If we lever this treated to match the ex post volatility of the market, 1 we obtain levered risk parity. The strategies are rebalanced each month.
Strategy performance is evaluated in different time periods and before and after adjusting for market frictions. Our long study period is 1926-2010, and we also consider four important superiors. The Pre-1946 Sample, 1 926-?1 945, which included the Great Depression and World War II, was also plagued by deflationary shocks and inflationary spikes. From an historical perspective, equity markets were relatively calm during the The Post-War Sample, 1946-?1982. However, this period included a bout of severe inflation and high interest rates that translated into poor stock and bond performance.
The Bull Market Sample, 1983-2000, included a huge bond rally and the game-changing emergence of the technology industry. The Last 10 Years felt turbulent, although they were, in fact, much calmer than the initial years of the study period. The information required to reproduce our results is in Appendices A and B. We find that strategy performance depends materially on the analysis period. Our results are consistent with, but not sufficient to demonstrate, the assertion that risk parity tends to outperform in turbulent markets.
By extrapolating transaction costs based on recent experience to our entire study period, we find market frictions are a substantial drag on performance. However, since we do not know how the availability of modern financing methods during the period 1926-1971 might have affected the course of history, our results should be interpreted with caution. The Specific Start and End Dates of a Backrest Can Have a Material Effect on the Results Figure 1 shows cumulative returns to the four strategies over the period 926-2010.
Levered risk parity had the highest return by a factor of three. However, the performance was uneven, as shown in Figure 2, where the eight-and-a-half decade study period is broken into four, substantial us periods. On the basis of cumulative return, levered risk parity prevailed during the the Prepare Sample and the Last 10 Years. In the most recent period, even unleavened risk parity beat the value weighted and 60/40 strategies. During the post-war period from 1946 to 1 982, both the 60/40 and value weighted strategies outperformed risk parity.