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

Abstract

Inter-temporal risk parity is a strategy that rebalances risky assets and cash in order to target a constant level of ex-ante risk over time. When applied to equities and compared to a buy-and-hold portfolio it is known to improve the Sharpe ratio and reduce drawdowns. We apply inter-temporal risk parity strategies to factor investing, namely value and momentum investing in equities, government bonds and foreign exchange. Value and momentum factors generate a premium which is traditionally captured by dollar-neutral long-short portfolios rebalanced every month to take into account changes in stock factor exposures and keep leverage constant. An inter-temporal risk parity strategy re-balances the portfolio to the level of leverage required to target a constant ex-ante risk over time. Value and momentum risk-adjusted premiums increase, sometimes significantly, when an inter-temporal risk parity strategy is applied. Volatility clustering and fat tails are behind this improvement of risk-adjusted premiums. Drawdowns are, however, not smoothed when applying the strategy to factor investing. The benefits of the inter-temporal risk parity strategy are more important for equity and foreign-exchange factors, with the strongest volatility clustering and fat tails. For government bond factors, with little volatility clustering, the benefits of the strategy appear less significant.