Risk parity and volatility timing on the Johannesburg Stock Exchange

Abstract

Risk parity has been described as a relatively new approach to portfolio creation that has been gaining popularity (Sullivan, 2010). Under risk parity, the efficient portfolio is created by weighting assets by their risk rather than by their market value. The resulting risk parity portfolio is then combined with either borrowing or lending the risk-free asset to achieve a desired mean-variance outcome. Volatility-timing is a market timing technique that seeks to exploit a weak relationship between short-term volatility and short-term return to improve the mean-variance outcome of a portfolio. The study examined the effect of volatility-timing on a risk parity portfolio to document the effect on the JSE. This serves to broaden the understanding of volatility timing and explore practical investment opportunities. A risk parity portfolio was created using index funds over the last 18 years to compare performance with a 60/40 benchmark. In addition, differing methods of leverage application were explored, including a volatility-timing method to identify an optimal leverage methodology. Risk parity was found to provide no risk-adjusted benefits to portfolio creation over the 60/40 portfolio. In addition, the approach to applying leverage, including a volatility-timed approach, provided no opportunity to capture excess returns.