Intertemporal risk parity: a constant volatility framework for factor investing

ABSTRACT Intertemporal 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 with a buy-and-hold portfolio it is known to improve the Sharpe ratio and reduce drawdowns. We apply intertemporal 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, bond or foreign exchange factor exposures and keep leverage constant. An intertemporal risk parity strategy rebalances 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 intertemporal 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 intertemporal risk parity strategy are more important for factor premiums with strong negative relationship between volatility and returns, strong volatility clustering and fat tails.