Risk parity has become an increasingly popular portfolio construction technique in recent years. At its core, risk parity aims to allocate risk equally across various asset classes in a portfolio, rather than allocating capital equally. This approach leads to diversification benefits and can improve a portfolio’s risk-adjusted returns. When implementing risk parity, investors overweight lower-risk assets like bonds while underweighting higher-risk assets like equities. This necessitates the use of leverage to bring the risk allocation in line across assets. Risk parity portfolios have demonstrated strong performance during crises when correlations across asset classes spike. However, leveraging can also introduce risks like margin calls. Overall, risk parity offers investors an alternative to traditional capital allocation techniques, with the potential for diversification and performance benefits if implemented thoughtfully.
Risk parity focuses on allocating risk, not capital
The key distinction of risk parity investing is its focus on risk allocation rather than capital allocation. Traditional portfolio techniques like the 60/40 stock/bond allocation allocate capital equally across assets. However, this can lead to concentrated risk, as equities carry significantly higher risk than bonds. Risk parity corrects this issue by overweighting lower-risk assets so that each asset contributes an equal amount of risk to the total portfolio. This leads to greater diversification benefits. While equities may only make up 20% of a risk parity portfolio’s capital, their risk allocation will be equivalent to other asset classes.
Leverage allows lower-risk assets to be overweighted
A critical tool that enables risk parity’s unique risk allocation is leverage. Because lower-risk assets like bonds have less marginal risk per unit of capital, larger position sizes are required to achieve parity in risk allocation. To accomplish this overweighting, risk parity strategies use leverage to magnify positions in lower-risk assets. This allows fixed income and other defensive assets to contribute an equal share of total risk despite their lower risk profiles. However, leverage also introduces risks like margin calls. Portfolio managers must size leverage prudently and implement risk management tools to prevent forced selling of assets.
Diversification benefits can improve risk-adjusted returns
By correcting the concentration of risk in higher-volatility assets, risk parity can provide diversification benefits and improve risk-adjusted returns compared to market-cap weighted portfolios. Research Affiliates found that adding leveraged bonds to a stock portfolio significantly increased returns per unit of risk over the 1991-2010 period. Risk parity’s performance also holds up better during periods of market turbulence when correlations between stocks and bonds fall. However, risk parity’s use of leverage can also magnify losses during certain environments like rising rate regimes. Investors should be aware of these risks.
Risk parity asset allocation requires robust risk forecasting
Implementing risk parity requires accurate measurement of each asset’s marginal contribution to total portfolio risk. This is measured by the covariance matrix between assets. However, covariances are unstable over time. This makes risk modelling critically important but also challenging. Regular covariance matrix updates are necessary, but turnover costs can also undermine returns. Overall, risk parity’s asset allocation relies on risk forecasting abilities. Investors should partner with experienced risk parity managers with sophisticated risk modelling capabilities.
The performance of risk parity depends heavily on asset universe
As with any portfolio approach, the performance of risk parity hinges critically on asset universe selection. Research Affiliates found that including more asset classes did not necessarily improve risk parity performance. However, adding specific low-risk assets like aggregate bonds with attractive risk-adjusted returns did boost results. This highlights the importance of thoughtful asset selection in risk parity portfolio construction. There is no systematic theoretical basis for determining the optimal risk parity asset mix. So a defensible asset selection rationale combined with robust risk modelling is key to implementing risk parity strategies.
Risk parity is an alternative portfolio approach that focuses on equally diversifying risk across asset classes through leverage. This leads to overweighted bond positions and underweighted equity positions. The improved diversification can enhance risk-adjusted returns. However, leverage introduces risks that must be prudently managed. Critical components like risk modelling and asset universe selection require significant expertise. Overall, risk parity offers investors a diversified approach but must be thoughtfully implemented to maximize its portfolio benefits.