Risk parity investing: Balancing risk and return in portfolio allocation

Risk parity portfolios rely on risk-based diversification, aiming to generate higher and more consistent returns. Unlike traditional portfolios, these portfolios start with a lower allocation to equities and invest significantly more in other asset classes to evenly spread the risk budget across various asset classes.

The essence of risk parity lies in diversifying across asset classes that behave differently in different economic environments. While specific strategies may vary, they all share a balanced approach to risk allocation.

Benefits

Diversification: Risk parity involves investments in various asset classes such as stocks, bonds, commodities, and risk-free assets. This diversification spreads risk, increasing the likelihood of reasonable returns even during adverse market conditions.

Low cost: Risk parity portfolios lean towards passive management, resulting in lower fees compared to actively managed strategies. This cost-effectiveness makes the approach economical.

Safety in recession: During economic downturns, risk parity portfolios tend to perform better than traditional portfolios heavily invested in stocks and other risky assets.

Limitations

Market timing risk: Risk parity portfolios face the risk of market timing as the volatility of asset classes may fluctuate, potentially exceeding prescribed limits.

Leverage: Risk parity portfolios may require greater leverage to achieve similar returns compared to traditional portfolio management.

Monitoring: Although not actively managed, risk parity portfolios require constant monitoring to ensure that actual risks remain within predetermined budgets.

Portfolio construction & risk
management techniques

Breadth of instruments used: Risk parity portfolios can include a wide range of asset classes, enhancing risk diversification and portfolio efficiency.

Correlation and volatility forecasting: Incorporating correlations and volatility forecasts across different asset classes helps equalise risk contributions, maintaining a consistent risk balance over time.

Tactical over/underweights: Managers can adjust risk allocations based on tactical views, deviating from equal risk across categories as needed.

Different volatility targets: Adjusting leverage allows for the construction of portfolios with varying levels of volatility, offering flexibility in meeting investors’ risk preferences.

Trading systems and risk controls: Proprietary algorithmic trading systems and portfolio-level drawdown control systems can help reduce trading costs and minimise losses during challenging periods.

Fitting into your overall portfolio

Core/satellite approach: Risk parity portfolios can serve as the core holding of an investment portfolio, offering better expected risk-adjusted returns regardless of an investor’s risk appetite or return target.

Alternative investments: Some investors categorise risk parity as an alternative investment due to its use of leverage and derivative instruments.

Flexible allocation: Risk parity portfolios are often placed in the opportunistic or flexible investment bucket, reflecting their adaptable nature.

Global tactical asset allocation (GTAA): GTAA portfolios, with their dynamic allocation among global assets, are closely aligned with risk parity portfolios.

The potential advantages of risk parity, including reduced equity concentration and tail risk, have led to increased acceptance among large investors. Risk parity investing has gained prominence for its meaningful diversification compared to traditional approaches.