In our previous article, we proposed an all weather portfolio that was based on actual asset allocation instead of the real risk parity consideration. The allocations of the proposed Bridgewater All Weather Portfolio are as follows:
|Growth +||Growth -||Inflation +||Inflation -||Total||Fund|
|EM Debt Spreads||6.25%||8.33%||14.58%||PEBIX|
The percentages were derived based on equal spreads on the four corners of economic cycles. However, in Bridgewater's original presentation, the all weather portfolio should allocation 25% risk to each corner, instead of just simply the actual portfolio allocation.
To derive a more accurate portfolio, we extend the above work by treating the derived percentages as risk allocations instead of actual asset allocations. We then use 10 year standard deviation of a fund as its risk and solve a linear equation based on each fund's target risk allocation:
|Tgt Risk Allocation||Fund||Std Dev (Risk)||Actual Allocation %|
|Equities||18.75%||VTSMX (VTI, SPY)||0.21||6.23%|
|EM Debt Spreads||14.58%||PEBIX (PCY, EMB)||0.07||14.80%|
|Corporate Spreads||6.25%||VWEHX (HYG,JNK)||0.05||9.06%|
|Nominal Bonds||25.00%||VBMFX (AGG,BND,IEF)||0.04||42.30%|
Comparing the portfolio Bridgewater All Weather Portfolio With Risk Parity with the previous one, Bridgewater All Weather Portfolio, we notice:
- Total risk asset allocation (equities + commodities + high yield bond + emerging market debts) is reduced from 54.16% to 34.9%
- This makes the new portfolio fall into the conservative allocation category.
The following shows the performance comparison:
Portfolio Performance Comparison (as of 2/22/2013)
|Ticker/Portfolio Name||1 Week |
|1Yr AR||1Yr Sharpe||3Yr AR||3Yr Sharpe||5Yr AR||5Yr Sharpe||10Yr AR||10Yr Sharpe|
|Bridgewater All Weather Portfolio||-0.7%||-0.2%||2.8%||71.1%||9.2%||185.7%||7.0%||105.2%||8.7%||134.6%|
|Bridgewater All Weather Portfolio Risk Parity||-0.3%||-0.6%||5.0%||217.6%||8.3%||257.6%||6.9%||154.7%||7.3%||152.3%|
*: NOT annualized
**YTD: Year to Date
VFINX: Vanguard 500 index fund (similar to SPY or VOO)
VBINX: Vanguard 60% stock 40% bonds index fund
You can find more detailed year-by-year performance comparison here.
The risk parity portfolio has higher Sharpe ratio (1.52 vs. 1.34) and smaller maximum drawdown (15% vs. 20%). It is thus a better portfolio using risk adjusted return (Sharpe ratio) metric.
One should note that this portfolio can be further improved to allow long-term Treasury bonds (such as TLT), long-term inflation protected bonds (such as PIMCO's LTPZ), long-term corporate bonds (LQD) and other instruments such as international stocks (EFA or VEA), emerging market stocks (EEM or VWO). Furthermore, in the inflation and equity category, REITs (IYR or VNQ) can be added to increase diversification.
The takeaway is that ordinary investors can now mimic the well known institutional all weather portfolios using increasingly available ETFs to achieve a fairly reasonable return (10 year 7.3%).