Risk Parity: A Portfolio Allocation Approach

Risk Parity: A Portfolio Allocation Approach

A decade of challenging markets has increased investor interest in risk parity, particularly for equities. In 2018, it was estimated that the total risk parity-related assets under management (AUM) totaled $70 billion.

This article explains risk parity and how it allows investors to earn higher risk-adjusted returns than a typical asset allocation portfolio. In addition to identifying the fundamental distinctions between the various risk parity methods, this article tackles specific investor concerns regarding this strategy.

What is risk parity?

Risk parity is an allocation approach that utilizes risk to set allocations among the various investment counterparts. Using leverage, the investment method alters the Modern Portfolio Theory approach to investing.

As a reminder, the Modern Portfolio Theory aims to provide diversification to an investment portfolio across specified assets in order to maximize returns while following market risk parameters by analyzing the risk and returns of the portfolio.

Using risk parity methods, investors can determine the precise allocations per asset class in a portfolio to ensure optimal diversification for various investment objectives and investor priorities.

How is Risk Parity contributing to portfolio performance

Risk parity is intended to assist investors in maintaining a portfolio with substantial risk diversification benefits while fulfilling return expectations. The intelligent application of leverage accomplishes this outcome. In particular, leverage is employed to raise the capital market line's risk-diversified portfolio until it is risk-equivalent to the 60/40 portfolio. 

However, a targeted risk and return level determine the investment class proportions. Risk parity strategies have generally evolved and developed from the Modern Portfolio Theory standards. By using them, investors can target specific risk groups and divide risk across the entire investment portfolio to optimize portfolio diversification.

Figure 1: Volatility forecast between 60/40 and Risk Parity portfolios (2010-2015). Source: Wealthfront.

Most risk parity schemes aim for a 10% realized risk threshold, which is the historical risk profile of a standard 60/40 portfolio. A risk parity manager typically anticipates a 6% extra yearly return at this risk level. A traditional 60/40 portfolio has delivered around 4% yearly excess return over the past quarter-century.

Another approach to directly calculating historical correlations across asset classes is to include economic fundamentals. The primary determinants of asset class returns are growth and inflation, specifically how these economic factors perform compared to expectations. To attain a high level of diversification, a manager can create a portfolio with asset classes that react differently to changes in key economic variables. This method can be used without explicitly estimating the correlations between classes, but it can bring substantial operational risk to the risk parity investment approach.

Drawbacks of the method

Risk parity, like many investment techniques, has its detractors. This technique is frequently criticized for requiring leverage on low-risk assets, especially bonds. Risk parity results in an overweighting of bonds in order to equalize the risk contribution of all asset classes. In recent years, leveraged bond strategies have fared well due to the dramatic decline in interest rates since the commencement of the financial crisis in 2007. Critics of risk parity argue that investors should have modest expectations for the future performance of their bond holdings in light of the current interest rate environment.

A gradual increase in interest rates resulting from a period of economic stability and prosperity would be favorable for a risk parity strategy. In this scenario, bonds may underperform, while growth assets such as stocks, real estate, and credit spreads are expected to outperform. Risk parity would likely profit from exposure to inflation-sensitive asset classes, such as inflation-linked bonds and commodities, if interest rates rise in reaction to increasing inflation expectations.

In conclusion, due to the centrality of diversity to a risk parity approach, there will likely always be asset classes in the portfolio that underperform expectations. On the other hand, other asset classes may outperform. The objective of the approach is to enable the investor to collect the average risk premium across all asset classes over time in the most efficient manner feasible, hence providing a risk-adjusted return above the average.

…But may not be as effective as they once were

However, the environment has become challenging for investors in risk parity today. The cash flows generated by various assets have become homogeneous, resulting in identical exposures across asset classes. This makes it harder for risk parity investors to lower risk and exposes them to greater danger than anticipated. Diversification has always implied that if one component fails, another will succeed. Conversely, cash flows today are more analogous than they were five years ago. Hence investors are just stacking their exposures.

Given the macroeconomic environment and the efforts of central banks to terminate their experiment with enormous fortunes without weakening economies, there is widespread skepticism that risk parity measures will function as effectively as they formerly did.

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