What Is Risk Parity?
Risk parity is a portfolio allocation strategy using risk to determine allocations across various components of an investment portfolio. The risk parity strategy follows the modern portfolio theory (MPT) approach to investing. MPT seeks to diversify an investment portfolio among specified assets to optimize returns while adhering to market risk parameters by viewing the risk and returns for the entire portfolio. The concept of the graphical representation of a security market line (SML) is a part of this approach.
Traditional Portfolio Allocation Basics
Simplified allocation strategies such as 60/40 also use the modern portfolio theory in asset allocation. This approach holds to keep a percentage of particular asset classes, such as 60% stocks and 40% bonds allocation. The method aims at standard diversification and exposure within one's investment portfolio. In simplified allocation strategies using just stocks and bonds, allocations are usually more heavily weighted towards equities for investors willing to take on more risk. Risk-averse investors will typically have a higher weight in bonds for capital preservation.
- Risk parity is a portfolio allocation strategy using risk to determine allocations across various components of an investment portfolio.
- The risk parity approach to portfolio management centers around a modern portfolio theory (MPT) approach.
- MPT seeks to optimally diversify investments by viewing the risk and return of the entire portfolio as one.
- Risk parity typically requires quantitative methodology which makes its allocations more advanced than simplified allocation strategies.
Risk Parity Basics
Risk parity is an advanced portfolio technique often used by hedge funds. It typically requires quantitative methodology which makes its allocations more advanced than simplified allocation strategies. The goal of risk parity investing is to earn the optimal level of return at the targeted risk level.
With a risk parity strategy, an investment portfolio can include stocks and bonds. However, instead of using a predetermined proportion of asset diversification such as 60/40, the investment class proportions are determined by a targeted risk and return level. Risk parity strategies have generally evolved and developed from MPT investing. They allow investors to target specific levels of risk and to divide risk across the entire investment portfolio to achieve optimized portfolio diversification.
Risk parity strategies allow for alternative diversification in portfolios and funds. Following this agenda, portfolio managers can use any mix of assets they choose. However, instead of generating allocations to different asset classes to arrive at an optimal risk target, risk parity strategies use the optimal risk target level as their basis for investing. This goal is often achieved by using leverage to weight risk equally among different asset classes using the optimal risk target level.
With risk parity strategies, portfolio managers can derive exact capital contribution proportions of asset classes in a portfolio to achieve optimized diversification for a range of objectives and investor preferences.
Real World Examples
The AQR Risk Parity Fund invests globally across stocks, bonds, currencies, and commodities. It seeks to achieve optimal return through balanced risk investing. The Fund has a net expense ratio of 0.93 percent.
Horizon's Global Risk Parity ETF uses a risk parity strategy in its investments. The ETF uses an equal risk-weighted volatility distribution to determine the amount of capital participation. There is a management fee of 1.27 %.