I ran across a nice piece on Risk Parity by Portfolio Probe. These days it’s rare that anyone other than Wai Lee at Neuberger Berman acknowledges that Risk Parity has broader applications than simply overweighting bonds with respect to equities.
One point I’d like to make on the Portfolio Probe post: like the author, I had also always thought that Risk Parity portfolios would always entail lower volatility than their market weight counterparts. Not so, I discovered.
Consider the S&P 500 Energy Sector. The Energy Sector is rare in that its two largest constituents, Exxon Mobil (XOM) and Chevron (CVX), also rank among its least volatile.
When you consider what Risk Parity means, it means the individual portfolio components’ contributions to portfolio risk are equal. Contribution to portfolio risk depends not only on the asset’s covariance with the portfolio, but also on its weight in the portfolio. XOM’s and CVX’s weights are so large, that even though XOM is the LEAST VOLATILE stock and CVX is the THIRD LEAST VOLATILE stock in the Sector, a Risk Parity Equity portfolio requires their weights to drop considerably. The other, more volatile stocks get higher weights, so the overall portfolio – while arguably better diversified – entails slightly higher expected portfolio volatility.
Below I list the top 5 and bottom 5 stocks in XLE, the Select Sector SPDR Energy ETF, based on portfolio weight, and their corresponding Risk Parity weight based on trailing two year weekly return data.
The resulting RP portfolio entails an estimated portfolio risk of 20.2%, versus 19.0% on the cap-weighted portfolio as represented by XLE constituents. (XLE is the Select Sector Spider ETF for the Energy Sector).
Here is a CSV file listing the respective portfolio weights, XLE_Parity_wts, as of Friday Oct. 28, 2011.