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First of two papers focuses on hedging forecast uncertainty
J.P. Morgan Asset Management has released the first of two new research papers looking at risk parity, a much debated asset allocation strategy that is a hot topic among many institutional investors globally.
The research paper, entitled Improving on Risk Parity: Hedging Forecast Uncertainty, is authored by Peter Rappoport, Managing Director and Global Head of the Strategy Group at J.P. Morgan Asset Management. The research addresses some commonly held misconceptions about risk parity, but draws on some of risk parity's strengths to propose an improved way of making asset allocation decisions.
Rappoport argues that allocating equal risk shares to asset classes as risk parity does cannot explain its past investment success. Equal risk shares, he says, is a "red herring" because the division of risk depends on how assets are defined, which is a purely cosmetic feature of a portfolio. However, in allocating equal risk shares, risk parity determines how to divide up a portfolio without using return forecasts. In contrast, standard asset allocation procedure relies heavily on forecasts.
Rappoport's analysis shows that sometimes it is better to ignore forecasts than use them in the standard way. This is because forecasts of future returns are inherently "uncertain." A forecast that equity returns will average 8% is a best guess, and does not rule out that the long term average could be 6% or 10%. However, the standard asset allocation model allows for no uncertainty, and can end up translating insignificant differences in forecasts into big differences in asset shares.
To deal with this problem, Rappoport proposes a hybrid strategy called the Forecast Hedge Rule. "This rule asks the investor for both forecasts of asset returns and a degree of confidence in them," Rappoport said. "The asset allocation it produces shades towards risk parity the lower the confidence the investor expresses in the forecasts. Only in the limit of complete confidence, at the other extreme, will the resulting asset allocation reflect the standard procedure."
Rappoport added: "I believe this research provides a novel perspective on risk parity, and gives our clients practical tools for their asset allocation."
The research will be made available to UK institutional clients this week. Copies of the paper are available to journalists on request. The second paper, Diversification - still the only free lunch?, is by members of J.P. Morgan Asset Management's Global Multi-Asset Group (GMAG), and will look at how some of the ideas in the first paper can be applied at a practical portfolio construction level. This paper is due to be released next week.
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