Risk Parity portfolios are also known as Equal Risk or Balanced Risk portfolios, because their portfolio risk is balanced equally among their components.
If you build investment products, manage client assets, or advise clients on asset allocation, chances are there is a place for Risk Parity among your portfolios. Risk Parity fits best wherever you don’t have distinct expectations on asset returns, and index weights are either non-existent or they don’t make sense.
No return forecasts? No problem
Risk Parity is a return-agnostic way to allocate assets: it does not require estimates of expected return – it simply requires a covariance matrix among the portfolio segments.
Like other return-agnostic methods including market weighting, equal weighting, and global minimum variance (GMV), RP does not require you to have forecasts or specific return expectations on individual portfolio segments. RP simply requires that you allocate a portfolio’s segments equally according to their contribution to portfolio risk.
No index weights? No problem
Compared to market weighting or conventional indexing, RP does not require knowledge of market weights or that the portfolio segments even have market weights. While it might seem strange to think of a conventional asset class as not having market weights, many alternative strategies do not have weights per se, including commodities, hedge funds, and managed futures.
Different from GMV portfolios
GMV portfolios are constructed so as to achieve the lowest possible volatility among the available assets. They are often quite concentrated among only a few of the assets. In contrast, Risk Parity portfolios have positive allocations to all available assets. While a RP portfolio’s predicted volatility is likely higher than a GMV portfolio’s volatility, if the investor’s assumptions about the assets’ volatilities turn out to be wrong – particularly among the lowest volatility assets – a GMV’s portfolio is probably more exposed to model risk than a RP portfolio.
Favorite tool of some of the world’s smartest, most sophisticated investors
RP portfolios are being used by some of the smartest, most sophisticated investors in the world. Strategies include mult-strategy hedge funds and commodities portfolios.
RP underweights higher volatility assets without excluding them
RP portfolios tend to have lower weights in higher volatility segments than in corresponding equal-weight or market-weighted portfolios, but higher weights than in a corresponding minimum variance portfolio. Pure low volatility portfolios and minimum variance portfolios often exclude higher volatility assets altogether, leaving these portfolios vulnerable to being left behind during periods when more volatile assets are in favor.
A former executive at a fund of funds which used a modestly leveraged GMV portfolio once asked me why anyone would use RP instead of GMV. The simplest explanation is a GMV allocation depends so much on the presumed lowest risk assets remaining such, while a RP portfolio affords an investor more room for error in making volatility assumptions.
Risk parity portfolios are highly tractable
In most cases, you can find the risk parity allocation by using Excel Solver. Risk Parity is an allocation method that should be part of every investor’s tool kit. It is not always the appropriate method to use, but if you advise clients or manage assets for them, Risk Parity should be part of your tool kit.
Contact Portfolio Wizards to explore how risk parity might make sense for your clients’ portfolios.