All of the examples thus far have weights that are based solely on the historical volatility over various periods.
The original Hedgefundie 40/60 weights are based on backfitting over several decades, and the weights are closely tied to a risk parity balance over this period. Other examples have weights based on the volatility over the trailing one to three months. A key assumption in risk parity is that expected return is proportional to risk, with the asset allocation determined to equalize expected risks given the assets in the portfolio. To the extent that asset risks are known, then a pure risk parity is market agnostic once the assets have been selected. The argument for using trailing volatility over a relatively short period, such as a month or quarter, to determine risk is typically that the current market risks are best estimated with recent information.
Some of the examples include tilts to the risk budget for the assets, with the tilts fixed at a constant value. A tilt away from equal risk budget weights serves to emphasize some assets at the cost of others. The emphasized assets might have better growth potential or lower volatility, depending on the desires of the portfolio manager. Setting a risk budget is akin to setting an asset allocation, except with a fixed risk budget the asset allocation changes over time and with a fixed allocation the risk budget changes over time.
There are various ways that one could introduce market timing into a scheme that uses risk parity, such as swapping assets in and out of the portfolio or adaptively adjusting risk budget weights.
The approach I discussed before (using the unemployment rate index
) adjusts the risk budget according to the unemployment rate. In this scheme, the risk budget allocated to UPRO is decreased each month that the unemployment rate is increasing and accelerating, and is increased each month that the unemployment rate is decreasing or the increase is decelerating. The risk budget is determined entirely by the macroeconomic indicator.
The next two figures illustrate the adaptive allocation of the risk budget for UPRO between 20 and 90 percent. The UPRO risk budget allocation drops from high to low over a minimum of four months, and increases from low to high over a minimum of 20 months.
In these figures, the timing of the UPRO weight changes is essentially completely determined by the unemployment rate.
As before, the variance-based methods perform slightly better than the volatility-based methods in terms of expected return and risk-adjusted return. The variance methods have approximately 800 bps larger expected CAGR than the 40/60 fixed weighting scheme.
The effect of the limiting budget is shown in the next figure. Widening the UPRO limits tends to increase the overall returns, but exposes the portfolio to increased drawdown from rapid events that are not signalled.