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 approach to portfolio management centers around modern portfolio theory (MPT) which seeks to optimally diversify an investment portfolio among specified assets.
BREAKING DOWN Risk Parity
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. Simplified allocation strategies such as 60/40 are based on MPT and hold a percentage of asset classes, such as 60% stocks and 40% bonds, for standard diversification and exposure within one's investment portfolio. This allocation seeks to generally target a hypothetical risk level graphed at the intersection of the efficient frontier and capital market line. 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.
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, 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 in order to achieve optimized portfolio diversification.
Risk parity strategies allow for alternative diversification in portfolios and funds. In risk parity strategies portfolio managers can use any mix of assets they choose. Risk parity strategies are comparable to the optimal point on the efficient frontier, determined by the intersection at which the capital market line and efficient frontier meet. 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 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. The goal of risk parity investing is to earn the optimal level of return at the targeted risk level.
Investing in Risk Parity Strategies
Several risk parity-specific products, including mutual funds, are available, and investors can also build their own risk parity portfolios through careful research or by working with a qualified financial professional. Funds can use an array of varying asset classes offering investors multiple options for a diversified portfolio. Many funds diversify among equities, fixed income, currency and commodities.
The first risk parity fund, the All Weather hedge fund, was introduced by Bridgewater Associates in 1996. Since then numerous indexes and funds have been developed with a risk parity focus. Hedge Fund Research is an entity involved in risk parity solutions. They have developed a series of risk parity indexes which include: HFR Risk Parity Vol 10 Index, HFR Risk Parity Vol 10 Institutional Index, HFR Risk Parity Vol 12 Index, HFR Risk Parity Vol 12 Institutional Index, HFR Risk Parity Vol 15 Index and HFR Risk Parity Vol 15 Institutional Index. These indexes achieve a total targeted risk level.
Other examples of risk parity funds include the AQR Risk Parity Fund (AQRIX) and the Horizons Global Risk Parity ETF (HRA).
AQR Risk Parity Fund
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 1.01%.
Horizons Global Risk Parity ETF
The Horizons Global Risk Parity ETF is an optimally diversified fund using a risk parity strategy. The ETF uses an equal risk weighted volatility dispersion to determine the amount of capital contribution. The Fund has a management fee of 0.85%.