Quant Who Coined Risk Parity Says Wall Street Has It Wrongby
PanAgora’s Edward Qian says strategy is ‘a way of life’
Main quantitative fund has returned 20 percent in 2016
Nowadays, it’s a rare selloff that isn’t blamed on the growing heft of a strategy called risk parity.
But to a 52-year-old quant who helped develop it, the problem isn’t that risk parity is too big, but too small.
From his office on Boston Harbor, Edward Qian of PanAgora Asset Management has made it his life’s work trying to prove that the strategy -- more popularly associated with Ray Dalio’s Bridgewater Associates -- isn’t just a tool for divvying up stocks and bonds in hedge funds. Nor is it the destructive force that critics say could ruin markets. Pointing to three small photos of star clusters propped up at the edge of his desk, Qian says its principles are to investing what gravity is to the universe.
“Risk parity is a way of life,” says the Hai’an, China native, who first learned English watching television sitcoms and now oversees investments at the $42 billion firm. “Top down, bottom up. Everywhere.”
Qian is no stranger to risk. In 1986, with only a suitcase and $100 in his pocket, he took a flight from Beijing to Tallahassee, Florida, with dreams of becoming an academic. It was a time of change in China, which was trying to modernize its schools a decade after the Cultural Revolution had brought the educational system to a virtual halt.
“I hadn’t had a salad before I got onto the airplane and I said, ‘What is this? How do you eat cold, uncooked vegetables?” Qian said. “I had to adjust.”
Three decades later and Qian finds himself on the cutting edge of finance theory with a fund that has not only returned 20 percent in 2016, but has a long-term track record that is the envy of Wall Street. His vision for risk parity goes deeper than even Bridgewater’s, which first served up the recipe for partitioning a portfolio according to volatility in the 1970s and is by far its biggest purveyor. Anywhere from $400 billion to more than $1 trillion is invested risk parity, making it a target for those who say its reliance on leverage exacerbates selloffs.
The strategy begins with the premise that standard portfolios are held hostage by their concentration of risky assets like stocks. Unless subdued, they can account for all of a manager’s gains or losses because they swing around so much. By balancing it all out and adding leverage, the influence of tamer assets increase and returns stabilize, the thinking goes.
That’s not enough for Qian, who sees volatility-weighting stabilizing every corner of a portfolio, from industries in a stock index, to countries in international benchmarks, even to the factors that underpin smart beta exchange-traded funds. Risk parity done like this is the driving force behind PanAgora’s gains this year, he said.
Quibbles about how to slice and dice a fund’s holdings sound trifling, but they underpin a multi-decade argument in finance over ways of maximizing returns. The debate has sprung into the public sphere via smart beta ETFs, which stopped following indexes based on market value on grounds that doing so ties their fortunes to megacap stocks whose best days may be behind them.
Risk parity, especially in Qian’s conception, takes that a step further, saying it isn’t the size of index members that pose the main threat to a portfolio’s stability, but their volatility. While Bridgewater and AQR Capital Management use it to segregate broad asset classes in multi-billion-dollar pools, at PanAgora, risk parity is applied to every sector in every asset class, before leverage is applied to boost returns.
“You have to pick your poison -- more risky assets or a more balanced basket with high leverage,” said Qian. “There’s a philosophical underpinning on why risk party has worked and why it should continue to work.”
Qian says that trying to convince the world of this risk-heavy framework has been an uphill battle. Every time bonds and stocks sell off simultaneously, he braces for the usual naysayers who describe risk parity as simply extra leverage in the bond market that sows havoc during in turbulent times.
“Every time people talk about it as a leverage bond portfolio, I just cry,” Qian said. “It’s not leveraged bonds. It’s a leveraged portfolio. ”
A fixation with keeping investments balanced is rooted in Qian’s resume, which begins during the internet craze as an analyst at Putnam Investments in 1998. He was hired following a fellowship at MIT, at a time when Wall Street was recruiting mathematicians in droves to devise quantitative trading programs.
With advanced math degrees from Peking University, Florida State and a post-doctorate fellowship at MIT, Qian never took an economics or finance class -- but he got an education at Putnam. Shortly after his arrival, the quantitative hedge fund Long-Term Capital Management crashed. Two years later the dot-com bubble burst.
“It would be surprising if you didn’t experience that emotional ride when the equity market was doing this and say, ‘How do I do things differently, how do I cushion my downside?’” Qian said.
The experience sent Qian back to his theoretical models and eventually to a financial conference speaking tour in which he discussed the benefits of focusing on loss contribution. While he’s the first to concede that the idea was percolating among others at the time, he thinks many were influenced by his public talks. By 2004, he had finished writing his seminal paper for the Journal of Investment Management, which was among the first to give the strategy a name.
Labeling Qian a risk-parity pioneer might rankle Bridgewater. On its website is a 5,500-word essay chronicling how Dalio transformed insights gleaned from the McDonald’s McNuggets supply chain into a grand theory of investment that stresses balancing assets for variations in inflation and growth. Whether it embraces the precepts Qian ascribes to the formula, the hedge fund has ridden its All Weather strategy to assets of $62 billion and a gain of 13 percent so far this year.
“All Weather wants to call itself risk parity because risk parity has become a popular category,” Qian said. “Who can blame them? They’ve been very successful so why would they change?”
Nitpicks about nomenclature don’t change the firm’s central role in the strategy’s development, according to Bob Prince, co-chief financial officer at Bridgewater.
“We originally developed All Weather back in the mid-90s and the purpose was to simply figure out what set of assets you could hold passively over time that would provide good returns across all economic environments,” he said in a telephone interview.
That Qian might have a claim to being first with a strategy that Bridgewater says it thought up during the Nixon administration reflects how hard it is to define risk parity. Both could be right in their own way. Indeed, the difficulty of arriving at an accepted standard has stymied efforts to build a benchmark to judge returns.
There’s a wide disparity in performance. In the wake of the taper tantrum, PanAgora returned 3.6 percent in 2013, while AQR’s risk parity fund declined 6.3 percent and the Salient Risk Parity Index was little changed.
“Unless we develop a standard definition of what we mean by risk parity, we’re not going to be able to construct the same kind of benchmark that we have for general equity investing like the S&P 500,” said Andrew Lo, finance professor at MIT’s Sloan School of Management and chairman of AlphaSimplex, a quant research firm. “Let the buyer beware: what you think you’re getting in a risk parity product may have nothing to do with what you want to achieve in terms of your portfolio objectives.”
Qian sees plenty of misconceptions that give the theory a bad name, or worse, dupe investors into buying an unstable fund. For example, managers tend to have excessive equity risk because they consider junk bonds to be a separate category. In reality, the two are highly correlated, he said.
Because risk-parity funds are so different, it’s impossible to conclude the strategy is responsible for the market’s every convulsion, said Lo and Qian. Among others, JPMorgan’s Marko Kolanovic has been vocal about the impact of quantitative strategies in exacerbating selloffs like the one in August 2015. But a few days of mayhem don’t unleash an avalanche of risk-parity selling, said Qian.
And whenever Qian gets frustrated with all the pushback, he thinks back to the “four stages of science” his MIT adviser taught him: first outright dismissal, then some curiosity, followed by partial implementation, and finally, acceptance.
“We’re still in the third stage with risk parity,” said Qian. “This is how science evolves.”