Kilroy and Audacity of Risk Parity

During the Second World War and the 1950s, the phrase "Kilroy was here" was very popular. Kilroy was an inspector on a US shipyard that built ships for the Navy. Each shift, workers left a mark with chalk to indicate where they arrived to place the rivets that held together the metal plates, because they were paid by the number of rivets installed. Kilroy noticed that sometimes workers arrived before their shift, erased the mark left by the previous worker and replaced it with another, further down the line. This way they fraudulently appropriated a portion of the work performed by the other worker. To avoid cheating, Kilroy wrote his mark of inspection: "Kilroy was here." Once the ship was completed and delivered to the Navy, the sailors who received it could see the marks in incongruous and inaccessible areas of the boat. The great popularity of this phrase refers to the apparent success of extraordinary and bold gestures, such writing a phrase on inaccessible places on the huge sections of ships.

In the area of portfolio construction, there is a theory that seems audaciously different when compared to the classical one, a kind of hat tip to Kilroy.

Let's first explore the classical simplified theory of a portfolio. Imagine a portfolio made up of 60% company stocks and 40% sovereign bonds. This is quite a common portfolio. The stocks bring in a capital gain when the market is rising, as well as potential dividends. The bonds in turn provide coupon income and repayment of principal at maturity, for reinvestment purposes.

Below is a table summarizing the characteristics of each of the asset classes in a portfolio of two US ETFs (exchange traded funds): SPY represents high quality market securities and SHY represents high quality bonds, whose maturity varies from 1 to 3 years. The 60% / 40% portfolio refers to capital. Each $100 of this portfolio is divided so that $60 is invested in SPY shares and $40 is invested in SHY shares (see prices in the table). This sample portfolio is based on two holdings, where the bond side yield is very low yield because of the short maturity of 1 to 3 years. Twenty year bonds like the TLT would offer a higher yield but also greater risk in the event of rising interest rates.

 Price Per ShareYield (expected)Standard Deviation (= risk)
SPY (stock portion) $200 14.2% 9.6%
SHY (bond portion) $85 0.4 % 0.6%

Note: For Canadian securities and ETFs, the standard deviation, volatility, or risk, is on the Montreal Exchange website.

Note that the portfolio provides good yield from equities relates, but very little from bonds. Why hold bonds then? One reason is that a portfolio thus constituted offers a profit if the market is rising. If the market is stable or if it declines, the bond portion is there to provide revenue independent of market developments. Another advantage is that if we place 100% of the capital in equities, the risk is high for all assets. The presence of bonds therefore "dilutes" the portfolio risk.

Now about the bold type of portfolio, called "risk parity". We call it bold because its principle is applied in hedge funds. There are several versions of this type of portfolio, but we describe the basic version here.

Note the expected return column in our table: in an ordinary portfolio this is what we look at; what counts. In a risk parity portfolio, we look primarily at the risk column, the standard deviation.

In the table we see that the SPY is 16 times riskier than SHY (9.6% divided by 0.6% = 16). The risk parity portfolio tells us that in order to have the same risk in both parts of the portfolio, we should invest 16 times more in SHY than in SPY to have the same risk. It is clear that the investment in equities is much smaller than in the conventional portfolio: In a bull market, the performance of this risk parity portfolio is certainly less impressive.

So in order to achieve a yield at least equal to that of the conventional portfolio, the investor must "use margin"; that is to say, they must borrow from their broker to increase the value of their portfolio to achieve a higher yield. How much margin? It depends: the returns shown for SPY are purely indicative and particularly dynamic, and they usually do not take into account dividends and reinvestment thereof. One may ask: what is the use of a risk parity portfolio if the return is lower than desired and in addition one must go on margin to improve the theoretically expected performance?

Some advantages of this type of portfolio:

  1. In general, a diversified portfolio is better than a non-diversified portfolio.
  2. Even on margin, this portfolio is less risky than a conventional or other type of portfolio. The last 25 years shows that the margined risk parity portfolio is approximately 50% less risky than conventional portfolio. In case of market decline, this portfolio is much better protected.
  3. In the table, the term "yield" is accompanied by "expected." Indeed, the indicated yield is only a hope. It is the fruit of probability calculations (ultimately subjective), or a projection of historical behavior. In real life, we can not know exactly what will happen. Moreover, the outcome of these forecasts change frequently. The word "expected" is rather an understatement, while the word "risk" is more concrete.

The main disadvantages of the portfolio in question are:

  1. Without the margin and in a bull market, the portfolio does not yield enough to justify it.
  2. Given the great importance given to bonds, this portfolio is highly sensitive to interest rates and much less sensitive to the performance of the securities market.
  3. Using margin, for example 50%, increase costs because of the loan and the costs of commissions generated by the addition or reduction of positions.

Risk parity portfolios are however a possibility that investors should consider. Here is a strategy that may seem audacious to many because of its novelty:

  1. We build a diversified portfolio based on risk parity.
  2. When the market is up, add margin.
  3. When the market is no longer increasing but in congestion (as in the last eight months) or moving downward, remove the margin.

Such a "bold" strategy would have been highly useful for example during the market decline of 2008 and 2009.

The author

Charles K. Langford

Charles K. Langford

PhD, Fellow CSI

Charles K. Langford is President of Charles K. Langford, Inc, Portfolio Managers. He teaches portfolio management at School of Management (École des Sciences de la Gestion), University of Québec (Montréal). He is the author of 14 books on portfolio management, derivatives strategies and technical analysis.

Until 2007 he has been vice-president overlay risk management for Visconti Venosta Teaspoon Approach Management, Ltd. Until 1990 he was portfolio manager for Refco Futures (Canada) Ltd.

He has received a Bachelor degree from Université de Montréal, a Master degree and the PhD from McGill University (Montreal); he is Fellow of CSI (Canadian Securities Institute).