Risk parity (or risk premia parity) is an approach to
investment management
Investment management is the professional asset management of various securities, including shareholdings, bonds, and other assets, such as real estate, to meet specified investment goals for the benefit of investors. Investors may be institut ...
which focuses on allocation of risk, usually defined as volatility, rather than allocation of capital. The risk parity approach asserts that when asset allocations are adjusted (leveraged or deleveraged) to the same risk level, the risk parity portfolio can achieve a higher
Sharpe ratio
In finance, the Sharpe ratio (also known as the Sharpe index, the Sharpe measure, and the reward-to-variability ratio) measures the performance of an investment such as a security or portfolio compared to a risk-free asset, after adjusting for its ...
and can be more resistant to market downturns than the traditional portfolio. Risk parity is vulnerable to significant shifts in correlation regimes, such as observed in Q1 2020, which led to the significant underperformance of risk-parity funds in the Covid-19 sell-off.
Roughly speaking, the approach of building a risk parity portfolio is similar to creating a minimum-variance portfolio subject to the constraint that each asset (or asset class, such as bonds, stocks, real estate, etc.) contributes equally to the portfolio overall volatility.
Some of its theoretical components were developed in the 1950s and 1960s but the first risk parity fund, called the ''
All Weather'' fund, was pioneered in 1996. In recent years many investment companies have begun offering risk parity funds to their clients. The term, risk parity, came into use in 2005, coined by Edward Qian, of
PanAgora Asset Management, and was then adopted by the asset management industry. Risk parity can be seen as either a passive or active management strategy.
Interest in the risk parity approach has increased since the
financial crisis of 2007-2008
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fi ...
as the risk parity approach fared better than traditionally constructed portfolios, as well as many hedge funds.
Some portfolio managers have expressed skepticism about the practical application of the concept and its effectiveness in all types of market conditions
but others point to its performance during the
financial crisis of 2007-2008
Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fi ...
as an indication of its potential success.
Description
Risk parity is a conceptual approach to investing which attempts to provide a lower risk and lower fee alternative to the traditional portfolio
allocation
Allocation may refer to:
Computing
* Block allocation map
* C++ allocators
* Delayed allocation
* File allocation table
* IP address allocation
* Memory allocation
* No-write allocation (cache)
* Register allocation
Economics
* Asset alloca ...
of 60%
stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
s and 40%
bonds which carries 90% of its risk in the stock portion of the portfolio (see illustration).
The risk parity approach attempts to equalize risk by
allocating funds to a wider range of categories such as stocks, government bonds, credit-related securities and
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
hedges (including real assets, commodities, real estate and inflation-protected bonds), while maximizing gains through financial
leveraging.
According to Bob Prince, CIO at
Bridgewater Associates
Bridgewater Associates is an American investment management firm founded by Ray Dalio in 1975. The firm serves institutional clients including pension funds, endowments, foundations, foreign governments, and central banks.
It utilizes a glob ...
, the defining parameters of a traditional risk parity portfolio are uncorrelated assets, low equity risk, and
passive management
Passive management (also called passive investing) is an investing strategy that tracks a market-weighted index or portfolio. Passive management is most common on the equity market, where index funds track a stock market index, but it is becoming ...
.
Some scholars contend that a risk parity portfolio requires strong management and continuous oversight to reduce the potential for negative consequences as a result of leverage and allocation building in the form of buying and selling of assets to keep dollar holdings at predetermined and equalized risk levels. For example, if the price of a security goes up or down and risk levels remain the same, the risk parity portfolio will be adjusted to keep its dollar exposure constant. On the other hand, some consider risk parity to be a passive approach, because it does not require the portfolio manager to buy or sell securities on the basis of judgments about future market behavior.
The principles of risk parity may be applied differently by different financial managers, as they have different methods for categorizing assets into classes, different definitions of risk, different ways of allocating risk within asset classes, different methods for forecasting future risk and different ways of implementing exposure to risk.
However, many risk parity funds evolve away from their original intentions, including passive management. The extent to which a risk parity portfolio is managed, is often the distinguishing characteristic between the various kinds of risk parity funds available today.
Equally-weighted risk contributions portfolios
The best known version of risk parity is the equally-weighted risk contributions portfolio method.
Equally-weighted risk contributions is not about "having the same volatility", it is about having each asset contributing in the same way to the portfolio overall volatility. For this we will have to define the contribution of each asset to the portfolio risk.
Consider a portfolio of
assets:
, ...,
where the weight of the asset
is
. The
form the allocation vector
. Let us further denote the covariance matrix of the assets
=
, ...,
by
. The volatility of the portfolio is defined as the std of the random variable
which is:
:
:
Since
is
homogeneous
Homogeneity and heterogeneity are concepts often used in the sciences and statistics relating to the uniformity of a substance or organism. A material or image that is homogeneous is uniform in composition or character (i.e. color, shape, siz ...
of degree 1 in
, it follows from Euler's theorem for homogeneous functions that:
:
, where
:
so that
can be interpreted as the contribution of asset
in the portfolio to the overall risk of the portfolio.
Equal risk contribution then means
for all
or equivalently
:
The solution can be found by either solving the fixed point problem
:
or by solving the minimization problem
:
both with some constraint that eliminates the invariance of the problem with the scaling of
.
Usually either the overall portfolio volatility is set to
:
:
or the gross investment of the portfolio is set to
:
The above minimization problem can be efficiently solved by the
cyclical coordinate descent method, open source implementations of which are available in JavaScript, Python and R.
For ease of use, to also be noted that a REST API with capabilities to solve equal risk contributions problems, as well as constrained equal risk contributions problems, is available online.
History
The seeds for the risk parity approach were sown when economist and
Nobel Prize
The Nobel Prizes ( ; sv, Nobelpriset ; no, Nobelprisen ) are five separate prizes that, according to Alfred Nobel's will of 1895, are awarded to "those who, during the preceding year, have conferred the greatest benefit to humankind." Alfr ...
winner,
Harry Markowitz
Harry Max Markowitz (born August 24, 1927) is an American economist who received the 1989 John von Neumann Theory Prize and the 1990 Nobel Memorial Prize in Economic Sciences.
Markowitz is a professor of finance at the Rady School of Management ...
introduced the concept of the
efficient frontier
In modern portfolio theory, the efficient frontier (or portfolio frontier) is an investment portfolio which occupies the "efficient" parts of the risk–return spectrum.
Formally, it is the set of portfolios which satisfy the condition that no ...
into modern portfolio theory in 1952. Then in 1958, Nobel laureate James Tobin concluded that the
efficient frontier
In modern portfolio theory, the efficient frontier (or portfolio frontier) is an investment portfolio which occupies the "efficient" parts of the risk–return spectrum.
Formally, it is the set of portfolios which satisfy the condition that no ...
model could be improved by adding risk-free investments and he advocated leveraging a diversified portfolio to improve its risk/return ratio.
The theoretical analysis of combining leverage and minimizing risk amongst multiple assets in a portfolio was also examined by
Jack Treynor Jack Lawrence Treynor (February 21, 1930 – May 11, 2016) was an American economist who served as the President of Treynor Capital Management in Palos Verdes Estates, California. He was a Senior Editor and Advisory Board member of the ''Journal of ...
in 1961,
William F. Sharpe
William Forsyth Sharpe (born June 16, 1934) is an American economist. He is the STANCO 25 Professor of Finance, Emeritus at Stanford University's Graduate School of Business, and the winner of the 1990 Nobel Memorial Prize in Economic Sciences.
...
in 1964,
John Lintner
John Virgil Lintner, Jr. (February 9, 1916 – June 8, 1983) was a professor at the Harvard Business School in the 1960s and one of the co-creators (1965 a, b) of the capital asset pricing model.
For a time, much confusion was created because t ...
in 1965 and
Jan Mossin
Jan Mossin (1936–1987) was a Norwegian economist. Born in Oslo, he graduated with a siv.øk. degree from the Norwegian School of Economics (NHH) in 1959. After a couple of years in business, he started his PhD studies in the spring semester of ...
in 1966. However, the concept was not put into practice due to the difficulties of implementing leverage in the portfolio of a large institution.
According to Joe Flaherty, senior vice president at
MFS Investment Management
MFS Investment Management (MFS) is an American-based global investment manager, formerly known as Massachusetts Financial Services. Founded in 1924, MFS is one of the oldest asset management companies in the world and has been credited with pionee ...
, "the idea of risk parity goes back to the 1990s". In 1996, Bridgewater Associates launched a risk parity fund called the ''All Weather'' asset allocation strategy.
Although Bridgewater Associates was the first to bring a risk parity product to market, they did not coin the term. Instead the term "risk parity" was first used by Edward Qian, of
PanAgora Asset Management, when he authored a white paper in 2005.
In 2008 the name Risk Parity (short for Risk Premia Parity) was given to this portfolio investment category by Andrew Zaytsev at the investment consulting firm Alan Biller and Associates. Soon, the term was adopted by the asset management industry.
[The Institutional Investor, The Last Frontier, Francis Denmark, Sept 2010, page 7] In time, other firms such as
Aquila Capital
Aquila Capital is an investment management company with headquarters in Hamburg, Germany. It was founded in 2001 and focuses on sustainable investments, including renewable energy and green logistics, as well as real estate. Aquila Capital ...
(2004),
Northwater,
Wellington
Wellington ( mi, Te Whanganui-a-Tara or ) is the capital city of New Zealand. It is located at the south-western tip of the North Island, between Cook Strait and the Remutaka Range. Wellington is the second-largest city in New Zealand by me ...
,
Invesco
Invesco Ltd. is an American independent investment management company that is headquartered in Atlanta, Georgia, with additional branch offices in 20 countries. Its common stock is a constituent of the S&P 500 and trades on the New York stock exc ...
,
First Quadrant
A Cartesian coordinate system (, ) in a plane is a coordinate system that specifies each point uniquely by a pair of numerical coordinates, which are the signed distances to the point from two fixed perpendicular oriented lines, measured in ...
,
Putnam Investments
Putnam Investments is a privately owned investment management firm founded in 1937 by George Putnam, who established one of the first balanced mutual funds, The George Putnam Fund of Boston. As one of the oldest mutual fund complexes in the Unite ...
,
ATP (2006),
PanAgora Asset Management (2006),
BlackRock
BlackRock, Inc. is an American Multinational corporation, multi-national investment company based in New York City. Founded in 1988, initially as a Enterprise risk management, risk management and fixed income institutional asset manager, BlackR ...
(2009 - formerly Barclays Global Investors), 1741 Asset Management (2009),
Neuberger Berman
Neuberger Berman Group LLC is a private, independent, employee-owned investment management firm. The firm manages equities, fixed income, private equity and hedge fund portfolios for global institutional investors, advisors and high-net-wort ...
(2009),
AllianceBernstein
AllianceBernstein Holding L.P. (AB) is a global asset management firm providing investment management and research services worldwide to institutional, high-net-worth and retail investors.
AllianceBernstein's headquarters are located in Nashvill ...
(2010),
AQR Capital Management (2010),
Clifton Group (2011),
Salient Partners (2012),
Schroders
Schroders plc is a British multinational asset management company, founded in 1804. The company employs over 5,000 people worldwide in 32 locations around Europe, America, Asia, Africa and the Middle East. Headquartered in the City of London, it ...
(2012),
Natixis Asset Management (2013) and
Allianz Global Investors
Allianz Global Investors (commonly called AllianzGI or AGI), is a global investment management firm with offices in over 20 locations worldwide. It is owned by the global financial services group Allianz. Employing nearly 3,000, it manages over ...
(2015) began establishing risk parity funds.
Performance
A
white paper
A white paper is a report or guide that informs readers concisely about a complex issue and presents the issuing body's philosophy on the matter. It is meant to help readers understand an issue, solve a problem, or make a decision. A white paper ...
report from Callan Investments Institute Research in Feb 2010 reported that a "levered Risk Parity portfolio would have significantly underperformed" versus a standard institutional portfolio in the 1990s but "would have significantly outperformed" a standard institutional portfolio during the decade of 2000 to 2010.
According to a 2010 article in the Wall Street Journal "Risk-parity funds held up relatively well during the financial crisis" of 2008. For example, AQR's risk parity fund declined 18% to 19% in 2008 compared with the 22% decline in the
Vanguard
The vanguard (also called the advance guard) is the leading part of an advancing military formation. It has a number of functions, including seeking out the enemy and securing ground in advance of the main force.
History
The vanguard derives fr ...
Balanced Index fund.
According to a 2013 Wall Street Journal report the risk parity type of fund offered by hedge funds has "soared in popularity" and "consistently outperformed traditional strategies since the financial crisis".
However, mutual funds using the risk parity strategy were reported to have incurred losses of 6.75% during the first half of the year.
Proponents of risk parity argue that the value of balancing risks between asset classes will be realized over long periods including periods of recessions, growth and higher inflation regimes. Historical analysis does provide some evidence of better performance than equities in recessionary environments.
Reception
With the bullish stock market of the 1990s, equity-heavy investing approaches outperformed risk parity in the near term.
However, after the
March 2000 crash, there was an increased interest in risk parity, first among institutional investors in the United States and then in Europe.
USA investors include the Wisconsin State Investment Board and the Pennsylvania Public School Employees’ Retirement System (PSERS) which have invested hundreds of millions in the risk parity funds of AQR, BlackRock and Bridgewater Associates.
The financial crisis of 2007-2010 was also hard on equity-heavy and Yale Model portfolios,
but risk parity funds fared reasonably well.
Despite criticisms from skeptics, the risk parity approach has seen a "flurry of activity" following a decade of "subpar equity performance".
During the period 2005 to 2012 several companies began offering risk parity products including:
Barclays Global Investors
BlackRock, Inc. is an American multi-national investment company based in New York City. Founded in 1988, initially as a risk management and fixed income institutional asset manager, BlackRock is the world's largest asset manager, with trill ...
(now
BlackRock
BlackRock, Inc. is an American Multinational corporation, multi-national investment company based in New York City. Founded in 1988, initially as a Enterprise risk management, risk management and fixed income institutional asset manager, BlackR ...
),
Schroders
Schroders plc is a British multinational asset management company, founded in 1804. The company employs over 5,000 people worldwide in 32 locations around Europe, America, Asia, Africa and the Middle East. Headquartered in the City of London, it ...
,
First Quadrant
A Cartesian coordinate system (, ) in a plane is a coordinate system that specifies each point uniquely by a pair of numerical coordinates, which are the signed distances to the point from two fixed perpendicular oriented lines, measured in ...
, Mellon Capital Management,
Neuberger Berman
Neuberger Berman Group LLC is a private, independent, employee-owned investment management firm. The firm manages equities, fixed income, private equity and hedge fund portfolios for global institutional investors, advisors and high-net-wort ...
and
State Street Global Advisors
State Street Global Advisors (SSGA) is the investment management division of State Street Corporation and the world's fourth largest asset manager, with nearly $4.14 trillion (USD) in assets under management as of 31 December 2021.
The company ...
. A 2011 survey of institutional investors and consultants suggests that over 50% of America-based benefit pension and endowments and foundations are currently using, or considering, risk parity products for their investment portfolios. A survey conducted by Chief Investor Officer magazine in 2014 shows how far the adoption has grown: 46% of institutional investors surveyed are using risk parity and 8% are considering investing.
Use of leverage
According to a 2011 article in ''Investments & Pensions Europe'', the risk parity approach has "moderate risks" which include: communicating its value to boards of directors; unforeseen events like the 2008 market decline; market timing risks associated with implementation; the use of leverage and derivatives and basis risks associated with derivatives.
Other critics warn that the use of leverage and relying heavily on fixed income assets may create its own risk.
Portfolio manager Ben Inker has criticized risk parity for being a benchmarking approach that gives too much relative weight to bonds when compared to other alternative portfolio approaches. However, proponents of risk parity say that its purpose is to avoid predicting future returns.
Inker also says that risk parity requires too much leverage to produce the same expected returns as conventional alternatives. Proponents answer that the reduced risk from additional diversification more than offsets the additional leverage risk and that leverage through publicly traded futures and
prime brokerage
Prime brokerage is the generic name for a bundled package of services offered by investment banks, wealth management firms, and securities dealers to hedge funds which need the ability to borrow securities and cash in order to be able to invest ...
financing of assets also means a high percentage of cash in the portfolio to cover losses and margin calls.
Additionally Inker says that bonds have negative
skew
Skew may refer to:
In mathematics
* Skew lines, neither parallel nor intersecting.
* Skew normal distribution, a probability distribution
* Skew field or division ring
* Skew-Hermitian matrix
* Skew lattice
* Skew polygon, whose vertices do not ...
, (small probability of large losses and large probability of small gains) which makes them a dangerous investment to leverage. Proponents have countered by saying that their approach calls for reduced exposure to bonds as volatility increases and provides less skew than conventional portfolios.
Proponents of the use of leverage argue that using leverage can be risk-reducing rather than risk-increasing provided four conditions are met: (i) enough unencumbered cash is kept to meet any margin calls (ii) leverage is applied to a well-diversified portfolio (iii) assets can be rebalanced frequently and (iv) counterparty risk is minimized.
Risk parity and the bull market in bonds
A 2012 article in the ''
Financial Times
The ''Financial Times'' (''FT'') is a British daily newspaper printed in broadsheet and published digitally that focuses on business and economic current affairs. Based in London, England, the paper is owned by a Japanese holding company, Nik ...
'' indicated possible challenges for risk parity funds "at the peak of a 30-year bull market for fixed income". While advocates point out their diversification amongst bonds as well as "inflation-linked securities, corporate credit, emerging market debt, commodities and equities, balanced by how each asset class responds to two factors: changes in the expected rate of economic growth and changes to expectations for inflation".
A 2013 article in the ''
Financial News
''Financial News'' is a financial newspaper and news website published in London. It is a weekly newspaper, published by eFinancial News Limited, covering the financial services sector through news, views and extensive people coverage. ''Fin ...
'' reported that "risk parity continues to prosper, as investors come to appreciate the better balance of different risks that it represents in an uncertain world."
After the sharp fall in bond prices of 2013 ("taper tantrum"), investors continued to question the impact of rising rates on risk parity portfolios or other more concentrated equity portfolios. A historical analysis of episodes of rising rates show the value in distinguishing between orderly and disorderly rising rates regimes. Risk parity has weaker performance in disorderly rising rates environments but its performance over time is not dependent on falling bond yields.
Risk parity and the Capital Asset Pricing Model
Risk parity advocates assert that the unlevered risk parity portfolio is quite close to the
tangency portfolio, as close as can be measured given uncertainties and noise in the data.
Theoretical and empirical arguments are made in support of this contention. One specific set of assumptions that puts the risk parity portfolio on the
efficient frontier
In modern portfolio theory, the efficient frontier (or portfolio frontier) is an investment portfolio which occupies the "efficient" parts of the risk–return spectrum.
Formally, it is the set of portfolios which satisfy the condition that no ...
is that the individual asset classes are uncorrelated and have identical
Sharpe ratio
In finance, the Sharpe ratio (also known as the Sharpe index, the Sharpe measure, and the reward-to-variability ratio) measures the performance of an investment such as a security or portfolio compared to a risk-free asset, after adjusting for its ...
s.
Risk parity critics rarely contest the claim that the risk parity portfolio is near the tangency portfolio but they say that the leveraged investment line is less steep and that the levered risk parity portfolio has slight or no advantage over 60% stocks / 40% bonds, and carries the disadvantage of greater explicit leverage.
See also
*
Financial risk
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial ...
*
Hedge fund
A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as sho ...
*
Modern portfolio theory
Modern portfolio theory (MPT), or mean-variance analysis, is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. It is a formalization and extension of diversificati ...
*
Tail risk parity Tail risk parity is an extension of the risk parity concept that takes into account the behavior of the portfolio components during tail risk events. The goal of the tail risk parity approach is to protect investment portfolios at the times of econo ...
References
{{Financial risk
Financial markets
Actuarial science
Investment
Portfolio theories