Practical analysis for investment professionals
02 June 2016

Risk Parity Made Easy: Cliff’s Notes and Other Key Readings

Risk parity is a type of asset allocation strategy that has become increasingly popular in the aftermath of the global financial crisis.

Because the strategy evens out risk contributions from all major asset classes, it typically allocates more to fixed income than a traditional 60-40 portfolio ( i.e., 60% allocation to equity and 40% to fixed income). A 2015 Financial Times article provided an interesting if somewhat casual summary of the strategy’s history and the challenges it may face in a rising interest rate environment. It also quoted an industry estimate that put the asset under management (AUM) for risk parity strategies at US$400 billion.

So what is risk parity?

The rationale behind risk parity is intuitive and noble — at least to the believers.

Let’s start with why it is intuitive. A note from Bridgewater Associates, an investment firm that oversees US$150 billion in client assets, vividly described how its founder, Ray Dalio, “laid the foundation” of risk parity while developing the All Weather investment strategy. The idea for All Weather is simple: Different economic scenarios pose risks to different asset classes throughout the business cycle. Dalio and his team identified four major risk scenarios and made sure that at least a part of the portfolio could weather each risk. So this is where the All Weather is similar to risk parity: Instead of targeting optimal risk and return in the traditional portfolio optimization setting, both strategies strive to achieve balanced risk contributions from all asset classes.

The strategy is a noble one, its proponents maintain, because it is the ultimate diversification program. The traditional “efficient” portfolios tend to generate more risk from equities. Enthusiasts argue that only risk parity portfolios are truly diversified because they are equally sensitive to fluctuations in any risky asset. In comparison, the traditional portfolio is often more exposed to the risk of the economy missing market expectations for growth. This seems to make perfect sense, but a word of caution may be in order: While it may sound intuitive, this inference is not really backed by any particular research.

Is leverage essential to risk parity?

The “fancy” research on risk parity comes from Cliff Asness and his associates. They argue that an essential element of risk parity strategies is leverage. Here are Asness’s notes and the more involved version published in Financial Analysts Journal

Investors who do not fully understand risk parity strategies often are concerned that the strategy’s higher exposures to fixed income will cause it to underperform traditional portfolios with more equity exposures over the long run. This is only true in situations where investors cannot use leverage. Where they can, and CAPM allows for that, the levered-up risk parity portfolio should earn higher returns than traditional portfolios at similar risk level, or lower risk at similar return levels.

In their FAJ paper, Asness and his co-authors tested and confirmed a hypothesis that was first proposed by Fischer Black in 1972 as to why risk parity strategies work. In short, Black predicted that lower risk assets will outperform in terms of risk-adjusted return because investors do not want to lever up to invest in higher risk assets. That is, they suffer from leverage aversion. In this sense, leverage is a risk factor, just like the famous size or value factors, and earns a premium. The point Asness tried to make in the paper was that leverage is a risk worth taking as long as one does not go to the extreme.

How have risk parity strategies performed?

This question is a bit tricky because there are many varieties of risk parity strategies. In general, they worked better in the 1980s than in the 1990s. A Callan Associates’ white paper on the subject, although a bit dated, compared a generic risk parity strategy with the traditional alternatives and arrived at similar conclusions.

A good summary on the subject written in a style targeting industry practitioners, the Callan paper also made some interesting arguments on why leverage aversion is not so easy to deal with. The main thrust was that, in reality, it is not easy to determine the optimum level of leverage. Among other concerns, the paper also mentioned the need to update the monitoring, reporting, and risk management tools at the financial institutions employing these strategies with leverage. Building on that last point, I would add personnel training to the list of concerns as well.

In summary, risk parity is an asset allocation strategy in which each asset class contributes more or less equally to portfolio risk. Leverage is an essential element of the strategy, although for a variety of reasons many investors are not able to use leverage. Risk parity does not guarantee outperformance vs. more traditional “efficient” portfolios, though it can deliver better risk-adjusted return over the very long run.

Below are some of the key readings highlighted above:

  • A quick read on the subject for busy professionals: “Investing: Whatever the Weather?” (Financial Times)
  • The famed story of how Ray Dalio developed the All Weather strategy, which is similar to risk parity in spirit; an interesting read for history buffs and Dalio fans: “The All Weather Story” (Bridgewater)
  • Cliff Asness’s notes on why leverage is an essential element for risk parity strategies; accessible and yet rigorous: “Risk Parity: Why We Lever” (AQR Capital Management)
  • For the more quantitatively oriented: “Leverage Aversion and Risk Parity” (Financial Analysts Journal)
  • A good summary for investment professionals working in asset allocation but not intimately familiar with risk parity strategies: “The Risk Parity Approach to Asset Allocation” (Callan Associates, registration required)

For more in-depth coverage of these topics, Multi-Asset Strategies: The Future of Investment Management is available to CFA Institute members.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Larry Cao, CFA

Larry Cao, CFA, senior director of industry research, CFA Institute, conducts original research with a focus on the investment industry trends and investment expertise. His current research interests include multi-asset strategies and FinTech (including AI, big data, and blockchain). He has led the development of such popular publications as FinTech 2017: China, Asia and Beyond, FinTech 2018: The Asia Pacific Edition, Multi-Asset Strategies: The Future of Investment Management and AI Pioneers in Investment management. He is also a frequent speaker at industry conferences on these topics. During his time in Boston pursuing graduate studies at Harvard and as a visiting scholar at MIT, he also co-authored a research paper with Nobel laureate Franco Modigliani that was published in the Journal of Economic Literature by American Economic Association. Larry has more than 20 years of experience in the investment industry. Prior to joining CFA Institute, Larry worked at HSBC as senior manager for the Asia Pacific region. He started his career at the People’s Bank of China as a USD fixed-income portfolio manager. He also worked for US asset managers Munder Capital Management, managing US and international equity portfolios, and Morningstar/Ibbotson Associates, managing multi-asset investment programs for a global financial institution clientele. Larry has been interviewed by a wide range of business media, such as Bloomberg, CNN, the Financial Times, South China Morning Post and the Wall Street Journal.

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