Risk Parity Strategies for Investment Portfolios

Risk parity strategies offer great potential value to investment portfolios in today’s volatile economic climate, using leverage to balance contributions from stocks and bonds equally.

But do they work, and how can you integrate them into your portfolios? Learn more in this article.

Table of Contents

Leverage

Risk parity strategies rely on diversification through asset classes that perform differently in different economic environments. Stocks do particularly well during times of rapid economic expansion and moderate inflation; Treasury bonds, commodities, and trend-following strategies thrive when economic and inflation growth slow down or decline respectively. Risk parity tries to balance out these exposures by allocating weight relative to each asset class’s expected return based on risk or volatility – popularized by Ray Dalio’s Bridgewater Associates by using “true risk parity”, where assets weighted according to contribution rather than historical correlations alone.

Risk parity strategies utilizing leverage and short selling can amplify estimation errors relating to correlations and volatilities, leading to wide dispersions in performance. Managers experienced with leverage have discovered that risk-adjusted returns tend to be more stable when taking this approach; however, these strategies can cause great losses if mismanaged.

Alternative Diversification

There has been much buzz surrounding risk parity recently. From Bridgewater founder Ray Dalio touting its benefits (and touting All Weather Strategy), to Wealthfront providing this strategy as part of their offering to their clients, risk parity has certainly garnered the spotlight in recent months.

While risk parity approaches offer several compelling arguments, they also bring with them certain considerations that must be carefully assessed.

Risk parity refers to allocating assets based on their contribution to portfolio volatility, which can be measured using various methods such as volatility, variance and value at risk.

Estimation errors and widely varied projections of asset class volatilities and correlations are likely to lead to wide discrepancies in risk parity funds’ performance – particularly during difficult economic environments. A new framework must be created that integrates style factors and alpha sources more effectively for higher volatility or down market periods – this approach is called integrated risk parity.

Risk Targets

Risk parity portfolios seek to spread risk across assets in an attempt to ensure their exposure remains evenly spread, thus necessitating more leverage than more conventional asset allocation strategies. This should be taken into consideration as risk parity portfolios may increase volatility and drawdown risk for investors.

Risk parity strategies have long been held by proponents to outperform traditional 60-40 portfolios by investing primarily in stocks (60-40), as these typically deriv 90% of their risk from stocks, with returns from stocks ultimately determining its performance.

Risk parity strategies, on the other hand, are designed to go in one direction when others veer the other way and can protect investors during market downturns by shifting into more balanced portfolios when others falter. Unfortunately, their performance can often lag more concentrated portfolios during those times.

Portfolio Construction

Risk parity strategies employ low-risk asset classes as a hedge against higher-risk assets like stocks. This allows a portfolio to weather economic shifts more successfully. While such strategies are frequently measured against traditional 60/40 equity/bond portfolios, this doesn’t accurately reflect their construction nor risk/return characteristics.

Under rising-rate environments, risk parity products often underperform. This may be caused by rising rates causing bonds and inflation-hedging assets to move in tandem with equities – negating their diversifying effect.

Risk parity funds have the capability of avoiding this underperformance by adjusting their asset weights, using algorithms to continuously assess changing market environments and shift asset distribution accordingly. This allows them to keep risky components of their portfolio to a minimum while still producing substantial returns.