What is risk parity?

All theory is grey, dear friend /And green the golden tree of life. The words of Mephistopheles in the first volume of Goethe’s Faust distinguish academia from the attractions and contradictions of the real world. In the context of our supplement, to what extent should risk parity strategies diverge from the established definition of the approach: a quant-driven multi-asset fund with a more-or-less equal risk weighting to asset classes and some degree of leverage?

In the vibrant world of risk parity there are a variety of approaches and there is considerable flexibility between strategies. Some can be described as ‘core’ risk parity; others more active. Indeed, ‘risk parity’ is not a helpful label as there is no precise definition and no need for risk parity strategies to achieve precise parity between sources of portfolio risk.

Two perceived weaknesses of risk parity are its performance during periods of rising rates – performance was weak in 2013, the year of the ‘taper tantrum’ – and during extreme market events. But managers are keen to stress that performance need not drop off when interest rates rise. 

According to some proponents, leverage can actually reduce risk rather than magnify it, by creating greater overall diversification in the portfolio. BlackRock advocates the adherence to four ‘commandments’ within risk parity – sufficient cash to meet margin calls, portfolio diversification, asset liquidity and counterparty risk control.

Institutional investors are much more concerned about the sources of return than they were a few years ago. Interest in risk parity and similar approaches reflects investors’ greater knowledge and understanding of the sources of risk and return in portfolios. In equities, for instance, there is a more granular understanding of the contribution of risk premia such as value, momentum or low volatility. 

With greater knowledge about the sources of returns comes greater power to negotiate lower fees. The adoption of risk-parity type approaches by a few leading institutional investors, such as ATP in Denmark or Teacher Retirement System of Texas, will help others understand the value of a portfolio that focuses on the sources of return.

Fees will become a key topic of discussion if risk parity is ever to make it into the DC world. A relatively counterintuitive view is that risk parity is an easier concept to understand than most people think, particularly because it is agnostic about future returns, and that the return forecasts in a lifestyle portfolio are more complex.

Risk parity is perhaps best understood as an active source of a variety of market betas with volatility control. But the quantitative nature of the strategies and the variety of approaches surely calls for greater governance on the part of investors who exist, not in the realm of theory, but in the sometimes contradictory real world where regulatory requirements must be met, investment decisions answerable to trustee boards and pensions paid on time and in full.

Readers' comments (1)

  • I am glad the author began by pointing out the diversity of RP managers because years ago I think this was a common misunderstanding: that they all did things the same way.
    It has always surprised me that some people find RP difficult to understand but then again, financial professionals often have a way of making simple things sound complex, perhaps for very dubious reasons. The author attempts to define RP here, and although what he says is correct, it fails to address the key to RP: why leveraging/de-leveraging asset classes helps to equalize their returns and risk. (Admittedly, that cannot be summarized in one sentence.)
    Also glad that the common criticism “risk is not volatility!” was not mentioned. Hopefully that indicates that by now people realize that price swings do represent risk for many investors.
    Finally, I think one of the easiest ways to screw up a RP portfolio is by failing to properly diversify. For example: equities are equities. Don’t start thinking that small-cap and large-cap are two different asset classes that can diversify one another. That type of thinking works in a traditional pure equity portfolio but not in an RP portfolio!

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