Risk Parity: Trading Or Investing?

Risk parity is an investment strategy that seeks to balance the sources of risk in a portfolio. It is a portfolio allocation strategy that uses risk to determine allocations across various components of an investment portfolio. The risk parity approach modifies the modern portfolio theory (MPT) approach to investing through the use of leverage. Risk parity portfolios attempt to allocate funds to a wider range of categories such as stocks, government bonds, credit-related securities, and inflation hedges. Risk parity portfolios are more complex than simplified allocation strategies, requiring a great deal of quantitative calculation.

Risk parity is a portfolio allocation strategy

The MPT approach seeks to diversify an investment portfolio among specified assets to optimise returns while adhering to market risk parameters. However, it only utilises long and unmargined positions, and portfolios constructed using this approach are vulnerable to volatility and economic downturns.

Risk parity strategies, on the other hand, allow for the use of leverage, alternative diversification, and short selling. Portfolio managers can use any mix of assets they choose and determine the capital contribution proportions of asset classes to achieve optimised diversification for a range of objectives and investor preferences.

The risk parity approach seeks to allocate investment capital based on a risk-weighted basis to optimally diversify investments. It focuses on allocating risk, usually defined as volatility, rather than capital. Each source of risk carries a risk premium, which is a potential source of return. By adjusting the proportion of different asset classes based on their riskiness and the investor's risk appetite, risk parity aims to achieve better diversification than traditional allocation strategies.

For example, if stocks become more volatile relative to bonds, a risk parity portfolio will reduce the weighting of stocks. Conversely, if stocks become less volatile, their weighting in the portfolio will increase. An investor with a larger appetite for risk will likely have a risk parity portfolio weighted towards stocks, while a more risk-averse investor will have a portfolio weighted towards capital-preserving assets like bonds.

Risk parity is an advanced portfolio technique often used by hedge funds and sophisticated investors. It requires complex quantitative calculations and active management to continuously oversee and adjust the portfolio to maintain predetermined and equalised risk levels.

Risk parity modifies the modern portfolio theory (MPT) approach

The risk parity approach seeks to allocate investment capital on a risk-weighted basis to optimally diversify investments, viewing the risk and return of the entire portfolio as one. It builds on the modern portfolio theory (MPT) but allows for the use of leverage and short selling. MPT, on the other hand, seeks to diversify an investment portfolio among specified assets to optimize returns while adhering to market risk parameters. It views the risk and returns for the entire portfolio but only utilizes long and unmargined positions.

The risk parity approach attempts to equalize risk by allocating funds to a wider range of categories such as stocks, government bonds, credit-related securities, and inflation hedges (including real assets, commodities, real estate, and inflation-protected bonds). It also allows for the use of leverage and alternative diversification, along with short selling in portfolios and funds. Portfolio managers can use any mix of assets they choose and can use leverage to weight risk equally among different asset classes.

Risk parity requires a great deal of quantitative calculation, making its allocations more advanced than simplified allocation strategies. It is an advanced portfolio technique often used by hedge funds and sophisticated investors. It requires a complex quantitative methodology, which makes its allocations more complex than simplified allocation strategies.

Risk parity strategies allow for leverage and alternative diversification

Risk parity is a portfolio allocation strategy that uses risk to determine allocations across various components of an investment portfolio. It is a modification of the modern portfolio theory (MPT) approach to investing through the use of leverage. While MPT seeks to diversify an investment portfolio among specified assets, risk parity strategies allow portfolio managers to determine the exact capital contribution proportions of asset classes in a portfolio to achieve optimised diversification for a range of objectives and investor preferences.

Risk parity strategies allow for the use of leverage and alternative diversification, along with short selling in portfolios and funds. Portfolio managers can use any mix of assets they choose. However, instead of generating allocations to different asset classes to arrive at an optimal risk target, risk parity strategies use the optimal risk target level as their basis for investing. This goal is often achieved by using leverage to weight risk equally among different asset classes using the optimal risk target level.

With a risk parity strategy, an investment portfolio will often include stocks and bonds. However, instead of using a predetermined proportion of asset diversification such as 60%/40%, the investment class proportions are determined by a targeted risk and return level. Risk parity strategies allow investors to target specific levels of risk and to divide risk across the entire investment portfolio to achieve optimised portfolio diversification.

Leverage is also allowed with risk parity, so investors can borrow or sell short to achieve the best risk-reward trade-off. The use of leverage can be applied to portfolios that contain various assets. The key is that the assets in the portfolio do not have a perfect correlation. Leverage is used to equally distribute the risk among all of the asset classes included in the portfolio. Using leverage essentially increases the diversification in the portfolio, reducing the overall portfolio risk while still allowing for substantial returns.

Risk parity is vulnerable to shifts in correlation regimes

Risk parity is an approach to investment management that focuses on the allocation of risk, usually defined as volatility, rather than the allocation of capital. It is a portfolio allocation strategy that uses risk to determine allocations across various components of an investment portfolio.

The risk parity approach to portfolio construction seeks to allocate investment capital on a risk-weighted basis to optimally diversify investments, viewing the risk and return of the entire portfolio as one. It is an advanced portfolio technique often used by hedge funds and sophisticated investors.

While risk parity has gained popularity since the 2007-2008 financial crisis, it is vulnerable to shifts in correlation regimes. In Q1 2020, for example, a significant shift in correlation regimes led to the underperformance of risk-parity funds during the Covid-19 sell-off.

Correlation is a statistical measure of how two asset prices move in relation to each other. A correlation coefficient is a measure between -1 and +1. A correlation of -1 represents a perfect inverse relationship, while a correlation of +1 indicates a perfect linear relationship. A correlation of 0 indicates no statistical relationship between asset prices.

Including assets with negative correlations improves the diversity of a portfolio. However, correlation calculations are based on historical data, and there is no guarantee that these correlations will continue in the future. This is a significant criticism of risk parity.

When there is an increase in the correlation coefficients of underlying asset clusters, and their performance is also negative during the same period, the risk parity portfolio loses its diversification benefits. This scenario increases the risk of tail events.

For instance, in 2008, the correlation coefficient between stocks and commodities increased, and both assets performed negatively. A similar situation occurred in 2001 when the correlation between stocks and bonds rose to nearly 64%. In such cases, the risk parity portfolio is not diversified, and investors are exposed to higher risks.

Therefore, while risk parity offers an attractive risk/return profile compared to traditional portfolios, it is not a "free lunch." Investors should carefully consider the correlation coefficients of underlying asset clusters to avoid potential pitfalls.

Risk parity is a quantitative style of portfolio asset allocation

The risk parity approach modifies the modern portfolio theory (MPT) by allowing for the use of leverage and short selling. It seeks to allocate investment capital on a risk-weighted basis, optimising diversification and viewing the risk and return of the entire portfolio as a whole. This strategy is often used by hedge funds and sophisticated investors, requiring complex quantitative methodologies.

The goal of risk parity is to achieve better diversification than traditional allocation strategies, such as the 60/40 portfolio of stocks and bonds. By targeting a similar level of risk but in a more diversified manner, risk parity aims to outperform traditional portfolios. This is done by applying leverage to a diversified portfolio of asset classes, including stocks, bonds, commodities, and currencies.

Risk parity portfolios are constructed by considering the volatility of the assets included and using leverage to reduce and diversify equity risk. The use of leverage allows for borrowing or short selling to achieve the optimal risk-reward trade-off. Additionally, correlation between asset prices is an important concept in risk parity portfolio construction, as including assets with negative correlations improves portfolio diversity.

The extent of diversification in a risk parity portfolio can lead to large performance differentials, both positive and negative, relative to more traditional portfolios. While risk parity seeks to balance risk, it is not without its own risks. The use of leverage can introduce additional risks, such as the risk of counterparty default, and the need for active management and regular rebalancing.

Frequently asked questions