A Risk Weighted Approach Designed to Manage Bond Exposures in a Low Interest Rate Environment
28 Pages Posted: 5 Aug 2013
Date Written: August 5, 2013
Risk-based investing techniques such as risk parity are encountering market conditions no longer as favorable as in the past. Their principal weakness is the implicit assumption that the volatility of an asset is a fair quantification of investment risk. As a result, low volatility assets are assigned higher portfolio weights. In the case of bonds however, realized volatility is not a good indicator of risk in a low or rising interest rate environment. An approach that treats bonds on the basis of low historical volatility is therefore possibly building significant tail risk in its portfolios. In this paper, we propose an alternative risk-weighted approach to portfolio construction that enables investors to account for hidden risks in low volatility securities.
Keywords: Risk parity, volatility weighted portfolio allocation, bond risk, permanent portfolio, all weather portfolio
JEL Classification: C22, J11
Suggested Citation: Suggested Citation