Risk parity

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. Risk parity can also be a generalized term that denotes a variety of investment systems and techniques that utilize its principles. The principles of risk parity are applied differently according to the investment style and goals of various financial managers and yield different results. 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 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 late 2000s financial crisis 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 as an indication of its potential success. Risk parity is a conceptual approach to investing which attempts to provide a lower risk and lower fee alternative to the traditional portfolio allocation of 60% stocks 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 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, the defining parameters of a traditional risk parity portfolio are uncorrelated assets, low equity risk, and passive management. 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.