Inter-Temporal Risk Parity: A Constant Volatility Framework for Equities and Other Asset Classes

Inter-Temporal Risk Parity: A Constant Volatility Framework for Factor Investing

“…If average returns were constant, that would mean increasing the exposure to the financial asset in periods of higher risk-adjusted returns and reducing it in periods of lower risk-adjusted returns. But as shown by Perchet et al (2014), for asset classes such as equities and high yield there is even a negative correlation between returns and volatility which strengthens the effect. Fat tails, which, as revealed by Cont (2000), are present in the distribution of returns of most asset classes, tend to be stronger in periods of higher volatility.…”

“…We follow the approach described by Perchet et al (2014) and use the I-GARCH model which can be defined from the standard GARCH model propose by Engle and Bollerslev (1986) by setting the long-term average volatility ! D 0 and˛CˇD 1:…”

“…They relate the improvement in momentum risk-adjusted returns to the predictability of the momentum risk and also highlight that the management of risk seems to reduce exposure to fat tails. Perchet et al (2014) recently revealed that the strategy which rebalances the weight of an asset class toward a constant level of ex ante risk, an intertemporal risk-parity strategy, generates superior risk-adjusted returns when compared to a buy-and-hold portfolio, at least before transaction costs and market impact are considered. They show that the improvement in risk-adjusted returns is larger for risky asset classes such as emerging-market equities or high yield.…”

“…Developed equities and commodities also have higher risk-adjusted returns when managed at a constant risk, however, for investment-grade corporate bonds and in particular for government bonds, the improvement in risk-adjusted returns is negligible. Perchet et al (2014) provide a number of explanations for the improvement in risk-adjusted returns in constant risk strategies. First they highlight that in a world where returns follow normal distributions, the constant risk strategy would be equivalent to the buy-and-hold strategy since the volatility of asset returns would be constant over time.…”

“…In this paper, we extend the approach of Perchet et al (2014) to factor investing. We focus on value and momentum factors in equity markets, government bond markets and foreign exchange markets.…”