What Is Risk Parity?
Risk parity is a portfolio allocation strategy that uses risk to determine allocations across various components of an investment portfolio. The risk parity strategy modifies the modern portfolio theory (MPT) approach to investing through the use of leverage.
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, but only utilizing long and unmargined positions. 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 risk parity approach to portfolio construction seeks to allocate investment capital on a risk-weighted basis to optimally diversify investments, viewing the risk and return of the entire portfolio as one.
- The risk parity approach builds off of modern portfolio theory (MPT) but allows for the use of leverage and short selling.
- Risk parity requires a great deal of quantitative calculation, which makes its allocations more advanced than simplified allocation strategies.
Understanding Risk Parity
Risk parity is an advanced portfolio technique often used by hedge funds and sophisticated investors. It requires a complex 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.
Simplified allocation strategies such as the 60%/40% stocks-bonds portfolio make use of MPT. MPT provides a standard for diversification within one's investment portfolio that maximizes expected return for a given level of risk. In simplified MPT strategies using just stocks and bonds, allocations are usually more heavily weighted toward equities for investors who wish to take on more risk. Risk-averse investors will instead have a higher weight in bonds for capital preservation.
Risk parity strategies allow for both leverage and alternative diversification, along with short selling in portfolios and funds. Following this approach, 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.
Risk Parity Methods
With a risk parity strategy, an investment portfolio will often 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.
The security market line (SML) is another part of the risk parity approach. The SML is a graphical representation of the relationship between the risk and return of an asset and is used in the capital asset pricing model (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 SML is constant. The constant slope assumption, however, may not actually be realistic. For the traditional 60/40 allocation, investors must take greater risk to achieve acceptable returns and the diversification benefits are limited as more and 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.
Real World Examples of Risk Parity
Horizon's Global Risk Parity ETF also uses a risk parity strategy in its investments. The exchange traded fund (ETF) employs an equal risk-weighted volatility distribution to determine the amount of capital participation.