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In our previous article, we constructed an all weather risk parity portfolio using intermediate term bonds (AGG, BND) and inflation protected bonds (TIP). The idea is based on the all weather portfolio concept proposed by Ray Dalio's Bridgewater, one of the most successful hedge funds.

To recap the previous work:

The allocations of the previous Bridgewater All Weather Portfolio are as follows:

 Growth +Growth -Inflation +Inflation -TotalFund
Equities6.25%  12.50%18.75%VTSMX
EM Debt Spreads6.25% 8.33% 14.58%PEBIX
Commodities6.25% 8.33% 14.58%GLD
Corporate Spreads6.25%   6.25%VWEHX
Nominal Bonds 12.50% 12.50%25.00%VBMFX
TIPS 12.50%8.33% 20.83%VIPSX
     100.00% 

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.

In this article, we use long bonds instead of intermediate term bonds to increase durations while still maintaining the risk parity. The purpose is to see whether this can improve returns while still managing the risk in an acceptable level.

The following table shows the actual allocations once we replace intermediate term bond fund (VBMFX or AGG or BND) with a long term Treasury bond fund (VUSTX or TLT), and intermediate term inflation protected bond fund (VIPSX or TIP) with PIMCO long term inflation protected bond ETF (LTPZ). It again uses 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 AllocationFundStd Dev (Risk)Actual Allocation %
Equities18.75%VTI(SPY)0.1612.53%
EM Debt Spreads14.58%EMB (PCY)0.0624.68%
Commodities14.58%GLD (IAU,SLV,DBC)0.198.23%
Corporate Spreads6.25%JNK(HYG)0.0610.41%
Nominal Bonds25.00%VUSTX (TLT,VGLT)0.1320.65%
TIPS20.83%LTPZ (TIP,LTPZ)0.0923.5%
  Total Risk9.53100.00%

Comparing with the portfolio Bridgewater All Weather Portfolio With Risk Parity with this current one Bridgewater All Weather ETF Portfolio Long Bonds Risk Parity, we noticed that

  • No bond assets (Equities, Commodities) is increased from 11.07% to 20.76%.
  • Nominal bonds and TIPs are reduced from 65.07% to 44.16%.
  • Emerging market debts is increased from 14.8% to 24.68%, a big increase due to the reduction of bonds and TIPs.

The performance comparison:

Portfolio Performance Comparison (as of 4/4/2013)
 

 

Ticker/Portfolio Name1 Week
Return*
YTD
Return**
1Yr AR1Yr Sharpe3Yr AR3Yr Sharpe5Yr AR5Yr Sharpe10Yr AR10Yr Sharpe
Bridgewater All Weather ETF Portfolio Long Bonds Risk Parity0.8%0.2%10.0%2.3112.8%2.12    
Bridgewater All Weather Portfolio-0.3%0.4%3.8%1.158.5%1.817.0%1.098.8%136.1%
Bridgewater All Weather Portfolio Risk Parity0.2%0.1%5.8%2.587.9%2.56.8%1.547.2%152.1%
VBINX-0.1%5.7%9.3%1.319.6%0.935.9%0.417.8%54.4%

AR: Annualized Return

*: NOT annualized

**YTD: Year to Date

The relative short back testing history of the portfolio is due to the short history of LTPZ.

More detailed year by year comparison >>

(click to enlarge)

The 1 and 3 year annualized returns are improved dramatically while the Sharpe ratio is slightly lower than that of the previous Bridgewater All Weather Portfolio Risk Parity. The portfolio also out performed the standard 60% stock/40% bond Vanguard balanced index fund (VBINX). Furthermore, its Sharpe ratio is almost double over that of VBINX.

Note that since our previous two articles published on SeekingAlpha.com, we have received several comments. We would like to answer them here:

  • Why Gold (GLD or IAU)? Answer: there is no specific purpose to use Gold or a broad base commodity index fund such as DBC or GSG. In our 1st. article, the reason using GLD is really because GLD has relatively long price history so that we can get a longer back testing period.
  • Why so much emerging market debt? Answer: emerging market bonds are now tightly coupled with global inflation, growth and US dollar (weakness). However, we see no reason that an investor can eliminate or reduce this portion of exposure (while increasing other parts to maintain the same risk exposure in the Rising Growth and Rising Inflation corners).
  • How about using dividend paying equities (DVY, VIG, VYM, SDV, FVD) instead? Answer: we believe this is a good idea. Again, equity allocation will be increased if one were to use dividend paying ETFs instead as they generally have less risk thus its allocation will need to increase to maintain the overall equity allocation.

To summarize, it is possible to improve a risk parity portfolio's return by extending bonds' durations.

Source: Using Long Term Bonds To Improve Returns Of Bridgewater's All Weather Risk Parity Portfolio