Risk parity (or risk premia parity) is an approach to investment management which focuses on allocation of risk, usually defined as volatility, rather than allocation of capital. The risk parity approach asserts that when asset allocations are adjusted (leveraged or deleveraged) to the same risk level, the risk parity portfolio can achieve a higher Sharpe ratio and can be more resistant to market downturns than the traditional portfolio. Risk parity is vulnerable to significant shifts in correlation regimes, such as observed in Q1 2020, which led to the significant underperformance of risk-parity funds in the COVID-19 sell-off. Roughly speaking, the approach of building a risk parity portfolio is similar to creating a minimum-variance portfolio subject to the constraint that each asset (or asset class, such as bonds, stocks, real estate, etc.) contributes equally to the portfolio's overall volatility. Some of its theoretical components were developed in the 1950s and 1960s but the first risk parity fund, called the All Weather fund, was pioneered in 1996. In recent years many investment companies have begun offering risk parity funds to their clients. The term, risk parity, came into use in 2005, coined by Edward Qian, of PanAgora Asset Management, and was then adopted by the asset management industry. Risk parity can be seen as either a passive or active management strategy. Interest in the risk parity approach has increased since the 2008 financial crisis as the risk parity approach fared better than traditionally constructed portfolios, as well as many hedge funds. Some portfolio managers have expressed skepticism about the practical application of the concept and its effectiveness in all types of market conditions but others point to its performance during the 2008 financial crisis as an indication of its potential success.
Description
Risk parity is a conceptual approach to investing
which attempts to provide a lower risk and lower fee alternative to the "traditional" portfolio allocation of 60% in shares and 40% bonds which carries 90% of its risk in the stock portion of the portfolio (see illustration). 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), while maximizing gains through financial leveraging. According to Bob Prince, CIO at Bridgewater Associates, the defining parameters of a traditional risk parity portfolio are uncorrelated assets, low equity risk, and passive management. Some scholars contend that a risk parity portfolio requires strong management and continuous oversight to reduce the potential for negative consequences as a result of leverage and allocation building in the form of buying and selling of assets to keep dollar holdings at predetermined and equalized risk levels. For example, if the price of a security goes up or down and risk levels remain the same, the risk parity portfolio will be adjusted to keep its dollar exposure constant. On the other hand, some consider risk parity to be a passive approach, because it does not require the portfolio manager to buy or sell securities on the basis of judgments about future market behavior. The principles of risk parity may be applied differently by different financial managers, as they have different methods for categorizing assets into classes, different definitions of risk, different ways of allocating risk within asset classes, different methods for forecasting future risk and different ways of implementing exposure to risk. However, many risk parity funds evolve away from their original intentions, including passive management. The extent to which a risk parity portfolio is managed, is often the distinguishing characteristic between the various kinds of risk parity funds available today.
Equally-weighted risk contributions portfolios The best known version of risk parity is the equally-weighted risk contributions portfolio method. Equally-weighted risk contributions is not about "having the same volatility", it is about having each asset contributing in the same way to the portfolio overall volatility. For this we will have to define the contribution of each asset to the portfolio risk. Consider a portfolio of N {\displaystyle N} assets: x 1 {\displaystyle x_{1}} , ..., x N {\displaystyle x_{N}} where the weight of the asset x i {\displaystyle x_{i}} is w i {\displaystyle w_{i}} . The w i {\displaystyle w_{i}} form the allocation vector w {\displaystyle w} . Let us further denote the covariance matrix of the assets X {\displaystyle X} = ( x 1 {\displaystyle (x_{1}} , ..., x N ) {\displaystyle x_{N})} by Σ {\displaystyle \Sigma } . The volatility of the portfolio is defined as the std of the random variable w t {\displaystyle w^{t}}
X {\displaystyle X} which is:
σ ( w ) = w ′ Σ w {\displaystyle \sigma (w)={\sqrt {w'\Sigma w}}}
Since σ ( w ) {\displaystyle \sigma (w)} is homogeneous of degree 1 in w {\displaystyle w} , it follows from Euler's theorem for homogeneous functions that:
… excerpt ends here. Continue reading the full article.
