Multi Strat Series Dynamic Risk Parity Allocation Portfolio View - Financial Engineering Podcast With Mark Anderson Multi Strat Mark

Unpacking Dynamic Risk Parity: An All-Weather Investment Approach In a multi strategy framework, you need sleeves that do different things. We've got our Evolve book for premium capture, our trend following for crisis alpha and we've got dynamic risk parity, which is essentially our all weather approach with a brain. Think of it as Bridgewater's all weather approach to meets a commodity trend. Following risk parity is the foundation that gives us exposure to every macro regime, growth, recession, inflation, deflation. The momentum overlay lets you adapt dynamically to any asset class that stops working. Right now we're 57% in equities, 43% in inflation hedges like commodities and gold and not in bonds at all. That's not a view, That's what the signals are saying. Here's how it works under the hood. OK. And now we'll go and present. Oh yeah. So let's go over dynamic risk parity as a sleeve in a multi strategy hedge fund and how this risk parity makes money. So essentially what you're combining is 2 things, risk parity, which is equal risk contribution from asset classes. If gold is more volatile than the S&P, you'll allocate more gold. Then there's a momentum overlay showing that asset classes that tend to move more in certain macro environments, we will boost those more than an equal risk parity approach. So to kind of see this, about 40 to 50% of our profits are just going to come from a diversified exposure of multiple different types of risk, term premium and bonds equity, risk premium equities, long short equity and momentum. Then we'll have a momentum overlay on top of that where assets that are going up like golden last year, we'll put in more and assets that don't yield much like bonds, we're going to take out. We also mitigate drawdowns with smaller losses during crashes because we see the momentum of these trades and we generally look at them at 36 and 12 month overlay. Then we have the alpha of just our selection of kind of what ETS we're using or which allocation to asset classes we're using at the time. Overcoming 60/40 Portfolio Flaws with Dynamic Risk Parity So what's traditional risk parity and where does it fail? So generally, you want equal amounts of contribution. If you have a 6040 portfolio, the problem generally is 90% of your risk comes from stocks with a 60% allocation and 10% from lots. So your volatility in the stocks are 15 to 20%, whereas your volatility in bonds may only be 5 to 10. That's three times more risk of stocks, which works great when stocks are going up, but that obviously doesn't work on stocks trash. The solution with dynamic risk parity here is you're kind of looking at each asset class to go 25% in stocks, 75% in bonds, and your actual allocation will be 50% of your risk from bonds and 50% of your risk from stocks. So here's a general formula to understand. Regular risk parity is the weight in your portfolio as a percentage times expected volatility. You can look at a basis of slow medium past three months, six months, 12 months and their correlation to one another. And essentially your goal is high volatility assets have a lower weight. If you are invested in commodities for debasement, maybe you have 4 * 4 gold as compared to bitcoins. And then here's a multi asset approach where you look at U.S. stocks, international stocks, bonds, commodities and gold. You can see the raw weight and then the risk contribution is the same. Each asset has 25% of risk. So you need to crash scenario to get burned by everything. Why does this work? Theoretically when stocks fall 20%, your portfolio falls 15%. Bonds barely help, they only offset 10% of the risk. You're not really diversified. And then when stocks fall 20%, that's 25% of the risk in a risk area portfolio. The other 75% is uncorrelated alphas and therefore you get a smaller drop. Now I want to go into risk premium harvesting. This is basically seeking different times of risk premium that are uncorrelated. And when we look at this, we can see that our equity risk premium, which is stocks is 5 to 7% bond duration premium. The fact that 10 years and 30 years we need to get paid more on that no risk treasury in like a high yield savings account, commodity risk premium from inflation 2 to 4% and then basically just inflation going up, you know, not holding cash. We'll get that. It's diversified across all premiums, but here's the leverage question. Risk parity portfolios are bond heavy and bonds have low expected returns. So the solution is to use leverage. So we're not really getting up exposure. We can still get our 60% exposure bonds and we can use futures or return stack to have bonds. But this also cannot work because in 2022, bonds are more volatile than they have been in 20 years. And this obviously breaks through and this is kind of Bridgewater's total alpha type strategy. So what we do is we add a momentum overlay to this where static risk parity basically fails. Example like I talked here in 2022, bonds crashed. They were correlated to stocks. Basically it coupled all of the assumptions for financial advisors over the past, you know, 40 years and the correlation spike to .6 and there's no escape in your base. Implementing Dynamic Risk Parity with a Momentum Overlay But here's where dynamic risk parity and having a trend overlake out. When there's a positive trend rising prices, you will keep increasing the allocation. Generally we use three, 612 months. If all three are up, we would have a full weight. If the three month is below and the six and 12 months are above, we would have a medium weight and then negative trend. You would potentially take it out completely. If you know, here it is, 3612 months is all below. Here's an example of just how we kind of go about weighting it. You can see here example in bonds at three months return was negative 5%, six months was -10 and 12 months was 15 and 2022 strong negative modern bonds at all. This is where we're at currently. Then when you look at calculating this risk parity as a baseline, we'll take the current volatility for those rolling windows. Then we'll have the inverse of the volatility wait to have a signal. Here's just a baseline of an allocation that you may start with. Then when we apply the momentum overlay, if it's positive, we'll keep the baseline weight or increase it. If it's negative, we reduce the weight, possibly not even holding it. You can see the adjustment here. Stocks are weakening. We would go to 13%. International is getting stronger. This is kind of 2025 early. We'll increase the weight. Emerging markets with mixed signals. Long term bonds are deeply negative, so we got out of it. Commodity exposure up, gold obviously up significantly. And then just for the residual exits, we'll sit in cash for, you know, other stuff. And the other thing too here is like we want to implement these strategies in a low cost, so like VU and Q, low cost ETS, International Development markets and emerging markets. And then with all of these, we're basically able to allocate responsibly futures, obviously the most active one. I covered that in our last video. We'll link that below and we want to rebalance these quite often. Generally, we'll do it monthly and we want to keep the last month out of sample to kind of prevent any whip Shaws. Here's a current portfolio analysis of currently where we're sitting. We're mostly in developed markets 33%, physical gold 23%, commodities 20% and then we got the booze and NASDAQ and emerging market as well. We have nothing in TLT. We have no fixed income because these are all negative at the moment. With equities, we're showing basically U.S. stocks, which is S&P plus NASDAQ. It has a positive 3/6 and 12 month long return. So we obviously want to allocate to this. But the average international developed markets, strong momentum in Europe and Japan. We're breaking out overweight fees as well. Emerging markets, China's kind of weakness mostly due to kind of like NVIDIA stuff. And then inflation hedge with the basement. We're holding gold near all time highs, strong momentum on central bank buying commodities also high as well. Nice roll yield in backwardation as well. So we've combined all these bonds, no allocation basically because it's negative. How Dynamic Risk Parity Delivers Returns and Mitigates Drawdowns This is dynamic for parity in action then with regimes interpretation, growth plus inflation, great for equities, great for gold, great for commodities, not great for bonds. Bonds are generally a deflation play. So like think about after great financial crisis, this is kind of where you want to be in COVID. When we released rates to 0, this would be a traditional risk parity just based on historic volatility. 25% stocks, 50% bonds, 15% commodities, 10% gold right now or 56% stocks, no bonds, 19 cent commodity, 23% gold. And why does this work for commodities? Basically we have different commodity choices which we talked about in the last video, which would be passive indexes, roll yield and then commodities index. But kind of what we're doing is we're looking at roll yield as the biggest factor we want to avoid. Contango talked about this last time in examples of different weightings. We want to take into account inflation sensitivity and then that scarcity versus based an indicator as well. Again, rebalancing this quarterly a monthly, when we look at kind of performance of ETF's like hedger versus commodity index, you can see that outperforms during these series of time. And the other concept I want to go over here is alternative beta. So if you hold commodities, it's not necessarily an alpha even though it's calculated as its outperformance over the S&P, that's not correlated as alpha. It's more of a different way to extract a profit from the market that isn't directly correlated to the equities. And we just want to look at the regime where that does well. The best regime that commodities do well is, is basically inflation plus growth. With this dynamic risk parity, we're really optimizing commodities, which is the main value of what we get, but we're also able to get in and out of the general stock market to protect us. When we look at the risk parity premium, you have the momentum premium, you'll get drawdown medication and then through ETF selection minus your cost and fees is basically how you do it. The risk parity premium, which is just balancing out across assets is about half of our return. You can see we have diversified return streams from that and the diversification benefit of mixing multiple basically low sharp strategies together. An example I'll kind of give you this. If you go back to 1970 and you allocate all your money to gold or all your money to bonds, it ends up having the same return regardless which one you chose. But if you allocate it to gold and bonds, since they did exactly different times, it helps you compound more overtime and you would have done better by doing that then momentum. This is marryingly draw down mitigation. When we do this systematic based on our research and papers out of our AQR, we believe this is 2 to 5% alpha a year. It does relate in high turnover, but since these are they're already realized and they have the 6040 long term capital gains, short term capital gains and you can see that through trend falling. We expect 5 to 10% over cash and then by mixing it at responsible size, we expect 3 or 4% as well. Then draw down mitigation, which obviously it adds value because we're not paying that volatility drag 20%. Drawdown is 25% to return to get back to even. But the main benefit with drawdown here is mainly mental that you don't have to see big red numbers. So if you lose 15%, you need 17.6% and get back to even. We want to avoid that as much as possible. From avoiding that, we think it's 1 to 2% after a year. And then basically our allocation selection to superior ETFs. So like QQQ has like a .2 expense ratio. If you go into view, that'd be a little more responsible. Emerging markets like VWO versus DM is a cheaper contribution. And again, with the turnover of our portfolio, about everything is traded twice a year. There's another one to 2% alpha. This is mainly mitigating the cost of doing it more than alpha, but I just want to show how you need to obsess over basically the manufacturing and efficiency of what you're trading. Then obviously trading costs. We do think that this drag is about 25 basis points a year just from basically getting into strengths and everything and selection of the return breakdown. A hypothetical example you see here across stocks, emerging markets, bonds, quantities and gold, when you're calculating the volatility, it'll basically show you what the expected returns are. Whereas when you have static risk parity, you would basically look at stocks, commodities, bonds and never change this. Your bond allocation would be ripping you right now. Whereas when we apply some of these factors of the formula, we can see that we get alpha from, you know, allocating more international stocks than U.S. stocks. We get alpha from putting more commodities and not putting it in bonds, as well as allocating more goal. So you can see the benefits of all of that over time. And you can just see kind of with our back test here, we have close to 0 equity beta with a volatility lower than the stock market, not a crazy sharp ratio, but again, this is pretty nice tax efficient, much lower drawdown with everything. Observations here, 2023, the stock tested well. 2024, we did very good because everything's going up and then 2020, 5 by catching the gold and developed markets that contributed a lot. We know that the correlations of these two kind of show more. What dynamic risk parity does is these are the correlations of all of each other. Mixing these together will basically help that over time. Practical DRP: Optimal Market Regimes and Implementation Tips And then when does this work and when does this not work? An example is a trending market which is 2023 to 2024 commodities traveling in 2022 and basically gold canal, very strong performance regime changes that will also outperform just because we're exiting losers, which is getting out of bonds in 2022, equity correlations change or inflation risk and then obviously inflationary environments that brings down equities and we'll get another stuff. The worst environments are going to be these choppy mean reverting markets. So you know, a little bit earlier this year in 2025 with basically the tariff stuff really range bound even markets. So it's kind of think of like 20/15/2016 and very low volatility equity melt UPS. You're not going to be able to get 30% returns with risk parity, but we know that we're not going to take the draw down. So we're fine with this over time. Also things like the flash crash or COVID or 911 you're never basically going to get out of and these are kind of regimes that we expect the performance into. Equity bull markets we should lag stock moderate growth, which is kind of a regular year in the S&P to slightly better. We should do well inflationary growth, full murder at like 2022, deflationary kind of just missing out on the draw down stagflation like the 70s and 80s will do well. Equity bear markets, again kind of neutral, not necessarily a risk and we'll actually do the worst in whip shop type markets. So this is just some guidance on what this looks replacements for a 6040 pretty easy just using 36 and nine month correlations. Here's kind of an example of something that you guys may be able to implement at home, which would be, you know, trend following with an ETF like DVMF, which is called a trend following. And then a low ball kind of long short strategy of BTA out with you know, just regular allocation to gold developed markets and new markets. So I just wanted to give a little understanding around risk parity and basically what it can do. You're going to get a little more tax inefficiency with what you're doing. This is really good for like an IRA or 4 O1 Ki Appreciate you guys for watching. And if you have any more questions on dynamic risk parity and kind of how to go about these things, I can obviously share this code. And I just want to give some insight on how we can allocate more intelligently, especially with markets at all time highs. This could be a better, more mentally kind source of edge for you to put in the market. Appreciate it. And I'll see you guys in the next one like and subscribe.