The risk parity approach to portfolio construction seeks to allocate the capital in a portfolio based on a risk-weighted basis. Asset allocation is the process by which an investor divides the capital in a portfolio among different types of assets. The traditional portfolio allocation is 60% to equities and 40% to bonds. However, this allocation does not work well during stock market drawdowns and economic instability. The risk parity approach attempts to avoid the risks and skews of traditional portfolio diversification. It allows for the construction of an optimal portfolio considering the volatility of the assets included in the portfolio.
Traditional Asset Allocation
The traditional wisdom is to allocate 60% of a portfolio to equities and 40% to bonds and other fixed income instruments. Another common maxim is to subtract the age of an investor from 100 to determine the percentage that should be allocated to bonds. While this will certainly create a more diversified portfolio than having just stocks or only bonds, it falls short of being able to withstand volatility and economic downturns.
With this traditional portfolio allocation, equities comprise 90% of the portfolio risk. Historically, equities have had three times the volatility of fixed income securities. The higher equity volatility overtakes the diversification benefits of the bonds. The traditional portfolio allocation did not fare well during the 2008 financial crisis, as equities dropped dramatically during the period's heightened volatility. Risk parity avoids this concentration of risk in equities.
Security Market Line
The risk parity allocation theory is focused on helping investors build portfolios that are sufficiently diversified, but still able to achieve significant returns. Risk parity uses the concept of the security market line as part of its approach.
The security market line is a graphical representation of the relationship between the risk and return of an asset. It is used in the capital asset pricing method (CAPM). The slope of the line is determined by the beta of the market. The line slopes upward. The greater the possibility for the return of an asset, the higher the risk associated with that asset.
There is a built-in assumption that the slope of the securities market line is constant. The constant slope may not actually be accurate. For the traditional 60/40 allocation, investors must take greater risks to achieve acceptable returns. The diversification benefits are limited as riskier equities are added to the portfolio. Risk parity solves this issue by using leverage to equalize the amount of volatility and risk across the different assets in the portfolio.
Use of Leverage
Risk parity uses leverage to reduce and diversify the equity risk in a portfolio while still targeting long-term performance. The prudent use of leverage in liquid assets can reduce the volatility of equities alone. Risk parity seeks equity-like returns for portfolios with reduced risk.
For example, a portfolio with a 100% allocation to equities has a risk of 15%. Assume a portfolio that uses moderate leverage of around 2.1 times the amount of capital in a portfolio with 35% allocated to equities and 65% to bonds. This portfolio has the same expected return as the unleveraged portfolio, but with an annualized risk of only 12.7%. This is a 15% reduction in the amount of risk.
The use of leverage can further be applied to portfolios that contain other assets. The key is that the assets in the portfolio do not have a perfect correlation. Leverage is used to equally distribute the risk among all of the asset classes included in the portfolio. Using leverage essentially increases the diversification in the portfolio. This reduces the overall portfolio risk while still allowing for substantial returns.
Role of Correlation
Correlation is an important concept in constructing a risk parity portfolio. Correlation is a statistical measure of how two asset prices move in relation to each other. The measure of a correlation coefficient is a measure between -1 and +1. A correlation of -1 represents a perfect inverse relationship between two asset prices. Thus, when one asset goes up, the other asset will go down all of the time. A correlation of +1 indicates there is a perfect linear relationship between the two asset prices. Both assets will move in the same direction with the same magnitude. Thus, when one asset increases by 5%, the other asset will go up by this same amount. A correlation of 0 indicates that there is no statistical relationship between the asset prices.
Perfect positive and negative correlations are generally difficult to find in finance. Still, including assets that have negative correlations with each other improves the diversity of a portfolio. Correlation calculations are based on historical data; there is no guarantee that these correlations will continue in the future. This is one of the main criticisms of both modern portfolio theory (MPT) and risk parity.
Rebalancing Requirement and Management
The use of leverage in a risk parity approach requires rebalancing assets on a regular basis. The leveraged investments may need to be evened out in order to keep the volatility exposure for each asset class level. Risk parity strategies may use derivatives, so these positions require active management.
Unlike equity stocks, asset classes such as commodities and other derivatives require closer attention. There may be margin calls that require cash to maintain a position. Investors may also need to roll positions to a different month rather than hold contracts until expiration. This requires active management of those positions as well as cash in the portfolio to cover any margin calls. There is also a higher degree of risk when using leverage, including the risk of counterparty default.
Similarities with Modern Portfolio Theory
MPT and the risk parity approach have a great deal in common. According to MPT, the total risk of any portfolio is less than the amount of risk for each asset class if the asset classes do not have a perfect correlation. MPT similarly seeks to construct a portfolio along the efficient frontier by including diversified assets based on correlations. Both MPT and the risk parity approach look at the historical correlation between different asset classes in portfolio construction. Increasing diversification can reduce overall portfolio risk.